The S&P 500 rose today for the 3rd day in a row. As I showed on May 30th, when the S&P is trading below its 200-day moving average and without the proper pattern of increasing volume, this has provided a short-run negative expectancy over the last 35 years. What was interesting about today’s rise is that it was so weak from a price perspective. This can be a sign that the bulls are losing momentum and the short-term tide is ready to turn back to the bears.

Below I show the results of buying at the close on a day where the S&P is below its 200-day moving average, has risen at least 3 days in a row and today’s rise in the smallest in percentage terms of any day during the rise.

This shows a negative expectancy greater than a normal 3-day rise in a long term downtrend. On May 30th I showed that volume rising two days in a row turned the 3-up days pattern from bearish to bullish. If I exclude those instances with bullish volume patterns the results are even more negative:

Also notable from today is that the Capitulative Breadth Indicator (CBI) returned to “3”. This is what I consider a neutral state. In other words, it is no longer suggesting an upside edge. For those keeping score, the “buy at 7 – sell at 3 or lower” trade would have netted about 2 S&P points from the “7” signal on the 10th to the close today.

On Friday the market put in some solid gains. The S&P 500 rose 1.5%, the Dow 1.4% and the Nasdaq 2.1%. In Gary Smith’s 1999 book, “How I Trade For A Living”, Gary, pictured at the right*, discussed how strong momentum on Fridays has a tendency to carry over to Mondays. If you’ve read the blog for any period of time, you’ll know that I tend to believe very little of what I read about the market. Hence my desire to test everything. So I put Gary’s theory to the test.

Tests were run on the S&P 500 going back to 1960. The table below shows the percent return on Friday in the left–most column. After that you see the breakdown of what happened on Monday. (Buying Friday’s close and selling Monday’s close.) Also, you should note that if Monday was a holiday, then the sale occurred on Tuesday’s close.

Looks like Gary (pictured above)* was on to something. Especially interesting is the fact that the stronger Friday is, the stronger on average Monday is. You can see this by looking at the average trade column.

But with the long term upward drift of the stock market how have these Mondays compared to the average Mondays? Believe it or not, Mondays since 1960 have been horrible. During the 60’s, 70’s, and 80’s, Mondays were consistent losers for the stock market. After the crash of ’87 (which happened on a Monday), they no longer acted as a consistent loser. Instead they fell more in line with general market direction. This can clearly be seen in the graph below showing all which shows the result of purchasing at Friday’s close and selling at Monday’s close over the last 48 years or so.

For the entire 48 year period the average Monday lost 0.04%. But when Friday’s were strong that momentum tended to carry through and turn Mondays positive. Since the end of the 80’s the advantage has been less pronounced, but still exists. The last table below again shows Mondays returns based on Fridays returns, but this time only back to 1990.

* Not really Gary Smith. Actually that’s Spongebob Squarepant’s pet, Gary the Snail.

No time for research tonight. I spent the night at the Garden. Yeah Celts.

In lieu of a study, I instead prepared a chart of the CBOE Total Put/Call Ratio. One thing traders need to keep in mind when looking at certain indicators is that they may change over time. The put/call ratio is a prime example of that. The chart below is weekly. The green dots are the Friday closing prices of the put/call ratio and the brown line is a 40-week moving average.

Often times I hear traders refer to absolute levels in put/call ratios as if they are significant. What you can see by looking at the chart above is that “significant” has change over time. From ’97 to ’02 a “spike” in the ratio over 1.00 could have been viewed as significant. A trader seeing such a reading may conclude that fear among option traders was running high. Now a reading of 1.00 is below average. A reading of 0.5 would sure be significant, though. In 2000 it was about average. Strategies that may have been developed 7 or 8 years ago that looked for a move to a certain number are now likely obsolete. That doesn’t mean the put/call ratio has stopped working as an indicator, though.

The issue lies in the fact that the popularity and use of options for traders and institutions has changed over time. It will continue to change. To adjust for this you should normalize the readings over a certain time period and then compare the current readings to “normal”. There are a number of ways to do this. Comparing to a moving average using percentages is a simple and effective one. Another way to normalize the put/call ratios would be to use Bollinger Bands (try varying lengths). The specific method is not terribly important. The fact that it is done is important if you don’t want your strategy or study to become obsolete.

The market sold off fairly hard on Monday with decliners swamping advancers by more than 2 to 1. Volume was light, though.

I ran a test to see how the S&P has reacted following a day when it was down at least 1% on 2:1 or higher declining breadth. What was most interesting about this test is that results were significantly different in the last 21 years than they were before that. From 1960 up until the Crash of ’87 the results were as follows:

From the Crash of ’87 until today they look like this.

Buying and holding for a week after such a day would have been a winning strategy every year since 1987 except in 2006. Prior to that – consistent loser. In case you’re wondering, using lower volume as a filter improved results slightly.

After spiking a little the week before last, the CBOE Put/Call Ratio dropped fairly sharply over Wed-Fri. Below is a study I ran last night showing the implications of similar drops: