Prepared by

Investment Research Institute, Inc.

This week marks the 10-year anniversary of the 1987 stock market crash. No doubt you are well aware of this fact in light of the extensive media attention given to remembering this event. Many analysts have been offering their opinions on whether a similar crash could decimate market prices again some time in the future. Most of the analysts have referenced fundamental or technical research to make their point (on both sides of the issue), but in our first segment, we are going to discuss the relevant sentiment factors of then versus now. The next topic in this issue of Schaeffer's Research Review explores a very effective sentiment analysis of the Dow Jones Industrial Average (DJIA). As you may be aware, options on the DJX (an index 1/100 the price of the DJIA) have recently begun trading on the Chicago Board Options Exchange. The sentiment analysis we present here will likely provide a very effective addition to a DJX option trading strategy. Finally, we move to a new analysis of one of our favorite sentiment indicators–the CBOE Market Volatility Index (VIX). Long-time readers have become familiar with our analysis of the VIX, but the study we discuss in this issue is slightly different from any mentioned previously.

The sentiment environment prior to the 1987 crash was decidedly different than it is today. Boiling the stock market down to its most basic terms, a decline can be set off by even a small amount of selling if there is virtually no one buying. After big rallies in which most every investor participates, the potential buying strength in the market has a tendency to dry up. This opens the door for a potential decline. One classic indication that this is the case is when short-term declines are greeted with complacency rather than fear. By the time an overwhelming consensus believes the market will continue to go up forever, those market players have most likely purchased as many shares as possible and retain no additional buying strength to provide support on a pullback. This is a very dangerous situation and one that was prevalent just prior to the 1987 crash.

Bullishly spun cover stories of major magazines often reflect an overwhelming optimism in the market. By the time a very optimistic cover story reaches the newsstands, much of the buying strength in stocks has been depleted. In September 1987, a bullish George Soros was featured on the cover of Fortune magazine, yet the market declined by more than 7% at its low point for that month. This is a great example of main stream complacency in the face of a short-term decline.

Compared to the sentiment surrounding today's market, the complacency of 1987 can certainly be viewed as excessive. The only magazine cover in recent times that can compare to the excessive complacency of the Fortune cover is the Business Week cover dated June 3, 1996. This cover described “Our Love Affair With Stocks.” One month later, the market declined over 10%. However, these losses were quickly recovered with the S&P 100 Index (OEX) advancing 11.8% from its low over the ensuing two months. Further, the decline of July 1996 was less than 1/3 that experienced over the same time frame in 1987.

There are certainly other factors that suggest today's environment is nothing like the wild optimism of 1987. In early October of that year, all of the top 10 timers in Timer Digest were bullish. Certainly one might be hesitant to go against the top market timers as a group, but when they all were in agreement, a well-versed sentiment analyst could see that the danger for a reversal was great. As of the most recent Timer Digest (September 15), seven out of the top 11 timers are bullish. Considering that the market has been in one of history's most fantastic advances over the past two-and-one-half years, this can hardly be considered excessively optimistic.

Taken by themselves, the aforementioned events prior to the 1987 crash may not represent enough complacency to suggest a severe market correction was on the horizon. However, combining them with other factors such as an analysis of the options environment certainly helps make the case.

Prior to the crash, traders had made a killing by selling puts on the OEX. As long as the market kept going up, the options expired worthless. As this activity became widely utilized, two main bearish implications became evident. First, an investor bullish enough to sell puts on the OEX most likely had already purchased as much stock as possible. Therefore, widespread OEX put selling indicates that potential buying strength had been significantly depleted a situation in which even a few sellers can push down stock prices.

The second bearish implication is a bit more complicated. An options market maker who buys the OEX put from the speculator becomes effectively “short.” To offset this position, the market maker buys a basket of stocks or futures contracts. When the options expire, the market makers become effectively “long,” so they sell their shares or futures contracts thereby creating downside pressure on the stock market. As more option contracts were sold on the open market, this inflicted more downside pressure on the market when those hedging positions were sold. If you recall, “Black Monday” followed an expiration Friday.

Today, there is not nearly as much wildly optimistic put option writing. Just prior to the 1987 crash, the prices of equally distant out-of-the-money calls and puts on the OEX were virtually the same. Today, an equally distant out-of-the- money put is priced approximately 39% greater than the call (prices of the November 980 call and the November 885 put taken at the close on October 14 with the OEX at 932.11). What this shows is that the put selling in 1987 was extreme enough to push put prices down to a level equal to that of the calls. There is no such excessive speculation today suggesting that considerably more potential buying strength remains in the market of 1997 compared to the market of 1987.

Last month, we showed how the use of put/call open interest ratios as a sentiment gauge helps the market timing of individual sectors. This month, we use the same methodology to measure the sentiment in the DJIA.

Open interest measures the number of open option contracts at each strike price for a given equity. Comparing the total open interest for calls to the total open interest for puts allows us to estimate how many speculators are “betting” the equity will rise versus how many are “betting” it will fall. Therefore, when the open interest put/call ratio (not to be confused with most other put/call ratios that track volume) is falling, more speculators are “betting” the stock will rise. A contrarian would view this bearishly reasoning that potential buying strength had been depleted to that point.

To calculate a composite put/call ratio for the DJIA, we first calculated the open interest put/call ratios for 26 of the 30 DOW stocks dating back to 5/29/96. (We omit the four most recently added equities–WMT, TRV, HWP, and JNJ–for data consistency.) Next, we calculated a DJIA composite open interest put/call ratio from the simple average of these 26 equity ratios.

Table 1 shows the movements on a percentage basis of the DJIA when the composite put/call ratio has a reading in the top 33rd (highest) percentile (P/C > 0.590) versus the movements following a reading in the bottom 33rd (lowest) percentile (P/C < 0.554).

Table 2 shows the movements on a percentage basis of the DJIA following extreme readings of this indicator.

Currently, the DJIA composite open interest equity put/call ratio is at 0.546, a relatively low reading. A recent low reading of 0.495 occurred on August 1st of this year that preceded a drop of 499 points in the DJIA over the following 10 trading days. Although this is a concern, such sentiment data must be viewed in conjunction with technical factors, which are currently quite strong.

In the September 1997 issue of The Option Advisor we gave a short description of the Chicago Board Options Exchange Market Volatility Index (ticker symbol–VIX) in the “Option Strategy of the Month” section. Included in the discussion was an explanation of how the VIX is calculated and a statement regarding how the movement of this “index” can be used to help in short- term market timing. This month, we will prove our claims about this young “indicator” by using an old analysis technique, Bollinger Bands.

As an oscillating indicator, the VIX generally helps us predict future market performance by gauging the level of fear in the market following a pullback. Although a complete discussion of how the VIX and OEX are related is beyond the scope of this discussion, our research has shown that a generally inverse relationship exists between these two indices. The Bollinger Bands we use are drawn two standard deviations above and below the VIX 21-day moving average. Because the VIX oscillates, a break above the upper band indicates that the index has reached an extreme high and will shortly begin to move in a downward direction. This band break would therefore be a bullish sign, since the OEX and VIX are inversely related. Conversely, a VIX move below its lower band would have bearish implications.

We studied these VIX band breaks for the period from 1/1/90 to 10/10/97 (even though the VIX has only been around since 1993, estimated back that data was provided by the CBOE). During those (nearly) eight years, there were 125 breaks of the upper band and 57 breaks of the lower band.

After upper band breaks, the market experiences an immediate boost that lasts until about the seventh or eighth day. Average market performance subsequent to lower band breaks takes a turn for the worse after one day and drops off sharply for the next 4 days before recovering. In fact, the amount of average underperformance for bearish signals is slightly greater than the amount of outperformance for bullish signals.

What is not immediately noticeable is the relative degree of strength shown by these signals. For example, after 5 trading days, the market is up 0.745% on average following bullish VIX signals and down 0.458% on average following bearish signals. This 1.20% gap is the largest we have seen from any dichotomous signals that we have ever studied. In other words, compared to other studies with a similar number of signals, the results of this study have yielded a more pronounced difference between bullish and bearish signals.

The overall market environment is quite positive right now and certainly unlike the market prior to the 1987 crash. There have been no significant cover stories that hail the market as unstoppable, and the general consensus among market timers is much more restrained. In addition, put option selling on the OEX is not excessive like it was in 1987. This suggests potential buying strength remains, meaning that the likelihood of significant downside pressure after options expiration is limited. To sharpen the focus of this general market background, we can use the DJIA open interest put/call ratio and the VIX to better gauge our entry and exit points. This sentiment analysis combined with effective technical analysis can certainly add value to any portfolio.

Mike Oyster, Jerry Wang, Tim Niebel

It seems that the only certainty in today's market is that there is a lot of uncertainty. From August 15 to September 2, the OEX had daily moves totaling more than 150(!) points but had a net move of only one point. The actual historical volatility measured over those 12 trading days was a whopping 28.73%. That kind of figure (last seen during the pre-Gulf War pullback) is usually the result of large and rapid market declines, not trading range activity.

This volatility has had several effects. VIX spikes upward that normally coincide beautifully with market bottoms have not been as effective recently because actual volatility has been responsible for the spikes instead of irrational investor fear (which is the true source of a bullish signal). Investor sentiment polls (Consensus Index Of Bullish Market Opinion and Investor's Intelligence), which are normally very slow moving, have whipsawed back and forth between opposite extremes in a matter of weeks. Single-day readings of the CBOE equity put/call volume ratios have also managed to flip from near bullish to near bearish levels in a few days. (Incidentally, we are not considering the October 3 break below the equity P/C ratio's lower Bollinger Band bearish because of the technical environment in which it happened. On that day, the market opened 1.5% higher and retained most of those gains until after 2:00. Call buying during that kind of market strength is expected and therefore not indicative of complacency.)

Actual volatility has been lower during the past month (12-day historical volatility is currently about 11%) but the wild market days of late summer have not been forgotten by investors as the VIX remains well above 20. This and the currently bearish reading of the equity P/C ratio make us cautious about the potential downside that still remains in the short term. However, the steadily decreasing historical volatility and the strength the OEX has shown relative to its 50-day moving average suggest that the worst may be over.

Jerry Wang

October 16, 1997 Investment Research Institute, Inc.

1259 Kemper Meadow Drive, Suite 100, Cincinnati, Ohio

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Consensus National Futures and Financial On Line Index

Copyright 1997, by Consensus Inc.  All American and Pan American rights Reserved. editor@consensus-inc.com

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