Bernie Schaeffer, the major domo at Cincinnati-based Schaeffer's Investment Research, is an options guru, a market technician, a natural-born contrarian, a gentleman and a scholar. He has also, since last March, been a bear, quite a transition for a market analyst who'd stayed doughtily bullish through most of the bull's decade-long romp.
But that doesn't bother him. What does, currently, is the complacency he detects among institutional investors, especially in the way they've been piling into riskless' options strategies in a trendless' market that's just broken some longstanding support levels.
KMW
What's your take on investor sentiment here, Bernie?
Still way too complacent. But then, why not, with Wall Street strategists recommending allocations of 72 percent to stocks, 3.8 percent to cash? I think, though, that we're in a very high-risk environment. I would point out to you what we are seeing in options sentiment. That is, the 21-day moving average of the CBOE equity put/call ratio. We look at it as an overall market-timing indicator, looking for indications of when sentiment is getting extreme. We've got data on it going back to 1990. What we are seeing is an interesting phenomenon, which is not surprising, when you think about bull and bear market dynamics. What seems to be happening is that, over the past few years, the peaks are starting to get higher and the bottoms are starting to get higher as well.
Why should that be?
Well, you would expect, as you move from a bull into a bear market environment, that when people get extremely bearish, their bearishness would go to even greater levels than it got to when they were getting bearish before. And people would never quite get as bullish, when they're feeling better in a bear market, as they used to get when they were feeling good in a bull market. That's what's happening. We recently got a bottom in the equity put/call ratio at about 0.6, which used to be a level where you would put in some nice peaks. But that's where it actually bottomed. We now have moved into the mid-0.60s on it. I suspect, if some of these negative possibilities come together, we could see the put/call ratio going to some sort of record, which would have people calling a bottom in the market, because the put/call ratio went so high. But all it would really mean is that, very understandably, as the bear market continued to knock stocks down, people were getting more bearish. It wouldn't mean that they are as bearish as they'll ever be. Simply, that as they recognize the bear, they get more bearish. So it'll be interesting to see if we put in a new high in the 21-day moving average of the put/call ratio, if this market continues to frustrate from here.
What else makes you think investor sentiment is still disturbingly complacent?
There are all kinds of things going on in the options market that point to that. Most of the talk you hear is that option volatility is very low, which means that the market isn't going anywhere. But what everyone seems to be forgetting here is that volatility is mean-reverting. Usually, in fact, when volatility contracts tremendously, it's a precursor of a big move. It's sort of like-
The calm before a storm?
Precisely. Now, although people usually want to buy options when volatility is low and options are cheap, not this time. This time, they want to sell calls against their stocks. And they want to buy stocks because they're cheap and sell some calls against them-even though they're not being paid much premium to do so.
Why is that?
Think, for a moment, about who has been making money in the market since April-May. Most traders are trend followers and there have been no trends (up or down) to follow over this period. Most long-term investors are flat. The only players who've been consistently making money over this period have been option premium sellers. But what has happened to option premiums amid this relentless premium selling?
Let me guess, they've fallen.
To record lows. What concerns me is that interest in selling put and call premium has nonetheless continued strong, even though option volatilities (the price that can be collected) are so low. The Nasdaq 100 Trust Volatility Index (QQV) is currently not far off the bottom of its roughly 40-70 range. Some options traders aren't worried, because market volatility has also declined sharply, and they figure low market volatility translates into lower risk in their positions. But that's the rub.
Meaning risk is actually higher, if this is a calm before a storm?
Exactly. Everyone with experience trading options knows that volatility is mean reverting' in the long run, though we often forget this maxim at precisely those times when it is most important to remember it. Remember the "this time it's different" arguments regarding valuation that were invoked near the peak of the Nasdaq bull market in 2000? Well, according to some big players in the options market "this time is different" for market volatility and we can continue selling cheap premium because this new market' isn't going anywhere.
Seriously?
Yes, there was an excellent piece, for example, on the Dow Jones newswire on Aug. 15, quoting a senior options strategist to the effect that "now we have to be receptive to the possibility that we might be entering a new phase where market volatility is going to decline and stay down…Not surprisingly, institutional investors [who've adopted this view] haven't let up selling options, even though investors typically see periods of low volatility as an opportunity to buy options… So as the Nasdaq Composite has slipped to a four-month low, many investors have sold options, both to generate income and to boost returns on their flagging portfolios, as well as to help reduce the cost of buying stocks as they looked for bargains." Another example comes from a Business Week piece called, A Deep Freeze in Options – low volatility is pummeling traders of puts and calls.' It's a quote from a risk manager for Botta Capital Management: "In a nutshell, there are no [option] buyers." It's my contention that those two quotes, taken together, form an incredibly powerful microcosm of what's wrong with this market and why we've not yet put in a market bottom.
Just because institutions are selling options?
What I am getting at is this: If this was a bear market bottom, fear would be rampant and investors would be selling a big chunk of what they own ("just get me out"). They'd also be buying put option protection at any price on any stocks they decided to hold. Instead, they are now selling call options on their "flagging portfolios" at ridiculously and historically low premiums. Will these trifling premiums protect them from the consequences of a major market plunge? Not enough to even mention. In addition, they're buying stocks that they consider "bargains." At bear market bottoms, nothing is considered to be a bargain, no matter how "cheap." Everything is for sale. Want some perspective on this? Consider that according to a book that I recommend to traders at every opportunity, Bill Eng's Trading Rules,' you could have bought a controlling interest in RCA, the Cisco of the 1920s, for $25,000, at the bottom of the stock market in 1932. At the top of the market in 1929, $25,000 would have bought an odd lot.
Surely someone must be buying options?
Sure, but the lopsided investment interest in selling premiums is manifest in many ways. The put/call ratio on what is by far the most actively traded option these days, the QQQs, has dropped precipitously to the area of 46 percent of open interest, puts to calls. Which means 46 puts are sold for every 100 calls, a level that was twice as high in May. It has come down from 92 percent from 46 percent over the past few months – during what you'd have to call at best a neutral period for the Nasdaq, more likely, negative. Yet nobody has bothered very much to buy put protection. Option premiums are pretty low overall. Put premiums, which are generally juiced up at any point relative to call premiums, particularly as you go to the spec end, to the out-of-the-monies, show very little of that bias these days. From an options standpoint, it's kind of scary. That's what investors were doing in '87. One of the warning signs before that market crack, as I recall, was the predominance of put sellers. While many got hurt in the 1987 crash, it was the put sellers who were totally destroyed. The lure of selling option premium became irresistible, and the market crash followed this frenzy of option premium selling. I remember a particular seminar presentation that was just blowing the doors off in the summer of '87, all about the sure-fire' strategy of selling puts. As a matter of fact, a few months after that crash, I put together a bullet point list of the factors that had caused me to be bearish ahead of it. And some of the other points on that list also seem particularly relevant today. Things like: "Wall Street strategists very bullish." We've already noted how familiar this sounds in the summer of 2001. "Big index option volume." Back in 1987, OEX volume and open interest had grown exponentially and dwarfed the individual equity options. It was supposed to be the next best thing to minting money. In 2001, it is QQQ option volume that has exploded to monstrous levels. Now, these days, they talk more in terms of "buy stock, sell calls," rather than in terms of "sell puts," as they did back then, but those are mathematically equivalent strategies. If you get a crash, you get killed. And your profit potential is very limited – essentially, to the premium you're receiving for selling these options. What really is a killer is that premium levels now are so low. So you're not even getting paid what you normally would to sell these options. So if this is the calm before the storm, these strategies are suicide. In other words, institutions are employing exactly the opposite of the textbook options strategy that would protect their longs in a weak market like this one, in which option premiums are low, which would be to buy puts. By doing so, they'd protect themselves fully below the put striking price should the market continue to weaken – and do so at a very modest cost for this downside insurance.
So are you predicting another market crash?
No, though I wouldn't rule out the possibility. What I am predicting most strongly is that this is not the bottom in this bear market, despite the collective wishes of the tech CEOs, Alan Greenspan and the option premium sellers. And the more they work to delay the inevitable, the more ugly the inevitable will be.
Aren't you being an alarmist? All the institutions are doing in selling calls is trying to scrape a little more performance out of their portfolios in a difficult, trendless environment. And what are the odds of a crash?
I'm not saying that they are high. Just that those risks aren't being priced into the options market. I'm not predicting a 22 percent decline in one day. But I certainly see the lack of concern about any risk of a crash as one of the many symptoms that we're not at the bottom yet. And there are potential crash triggers out there, particularly the dollar. You know how the currency markets can trade. I mean, we talk about the fact that stocks trade more like commodities these days. Well, the dollar is a commodity. You could be up to parity on the euro before you turn around, if some kind of a snowball gets rolling. Then what happens to stocks? What happens if bonds go to 5.75 percent or 6 percent as stocks are declining? Where are the valuation models at that point?
You're asking nasty questions there, Bernie.
I'm just saying, there are mechanisms. You can construct a scenario without having to be terribly imaginative about how something like this could get rolling in this pretty darn high-risk environment.
But you're a contrarian. Haven't things gotten bad enough in the corporate world to figure they can't get much worse-and to get invested?
Nowhere does that line of thinking show up more than in the semiconductor sector. But it's not contrarian at this point. Not when it's what so many investors want to believe. Look what happened when they announced some book-to-bill numbers recently that could be interpreted, I guess, as something less than disastrous. But still awful, something like $67 of orders booked for every $100 shipped.
So how low do you see the market going?
On the Nasdaq, I wouldn't be surprised if we had a test in the next 6 -12 months, not of the 2001 lows, but of the 1998 low, which was 1,357. My target is actually somewhere in the range of 1,300 -1,350, for two reasons. No. 1, since 1,357 was the low in 1998, it should provide some support, at least for a while. No. 2, there's a phenomenon that I've noticed in just about every one of the big tech names, with the exception of the ones that just refuse to go down (like Microsoft and IBM). What happens is that as they get down to 50 percent of their old highs, they find some support. And that was also the case with the Nasdaq down at the 2,500-2,600 level. But once they break that support, lo and behold, most of the techs are down another 50 percent before you know it. If that also happens in the Nasdaq, that would take the index down to something like 1,296. So somewhere between 1,300 and 1,350 is where I am drawing a line in the sand as a reasonable level this thing can go to over the next 6 – 12 months.
And after that?
Who knows.
What about the Dow?
Well, with that kind of level on the Nasdaq, I've got to say that we could probably see the Dow down around 7,500, the level where it found support in both 1997 and 1998. But my point is that the weakness, like the mania that preceded it, will continue to be concentrated in the Nasdaq. Nonetheless, the corollary to that is not to therefore go out and buy everything else. The corollary is more like, therefore, how much longer can the rest of the market levitate? You can add to my litany of potentially destabilizing factors the fact that we're down 70 percent or so on the Nasdaq without fund managers having to liquidate their portfolios due to redemptions. What happens when investors wake up to the fact that many of last year's favorite tech stocks are companies that may not exist in a couple of years?
So you're bearish on the Naz. You're bearish on the Dow. There are ominous similarities out there to 1987.
Right! If you're asking, "Can't this market rally. Couldn't we see 11,000 on the Dow?" the answer is sure. But I'm looking at the big picture, what are the potential rewards – and what are the definable risks. And there's no way that the potential rewards I see are worth the risks here.
Bummer, Bernie. But thanks.
Kathryn M.Welling is the editor and publisher of welling@weeden, an independent research service of Weeden & Co. L.P., Greenwich, Conn. http://welling.weedenco.com
