2 Things Too Wrong With This Market That We Just Can't Ignore

by: James Brumley

The equity-only put/call ratio is uncomfortably low.

The market's breadth and depth remain tilted in a bearish direction.

Any pullback is just that -- a pullback -- and not the beginning of a bear market.

At first glance this week's weakness could be chalked up to the market's usual ebb and flow. Indeed, we've seen soft patches plenty in the recent past, and so far none of them have derailed the bigger uptrend.

Nothing lasts forever, however, and as much as we'd all like to see the rally remain in motion, we all also know nothing lasts forever. There are even a couple of clues suggesting this amazing uptrend is finally coming to a close. While that's not a prognostication of a bear market, it is a warning to expect it when you least expect it.

Breadth and Depth are Bearish

The short version of a long lesson: The market's breadth (the number of advancing stocks compared to the number of decliners) and the market's depth (the volume of shares trading lower as opposed to the volume of shares trading higher) are a good barometer of a trend's overall health. In an uptrend, we see more -- and usually growing -- advancers and "up" volume. Conversely, in a downtrend should and usually do see more decliners and "down" volume. Sometimes though, the market looks like it's healthy when it may not actually be.

This is one of those times.

The image below compares the S&P 500 to the NYSE's advancers, decliners, up volume and down volume, from top to bottom. The histogram bars represent the daily advancers/decliners and the up/down volume. The lines that more or less trace each data set's daily value are a moving average line of each day's value. This moving average smoothes out the day-to-day volatility and turns it the data into a discernible trend.

Source: TradeNavigator

As you can see, though stocks aren't "getting killed" this week, decliners have decidedly overtaken advancers, and the NYSE's "down" volume bars have turned decidedly stronger than the "up" volume bars.

It's not a trend yet, to be clear. The graphic below explains why.

The image more or less plots the same information as the image above did, comparing the advancers/decliners for the NYSE, and the up/down volume data. What's different is (1) we've removed the daily histogram bars to make it easier to see, and (2) we've overlaid the advancer/decliner moving averages and overlaid the up/down volume moving averages; the red, dashed lines are the bearish ones, and the solid blue lines are bullish. In both cases, while the breadth and depth have been bearish for the past few days, it's not yet turned into a full-blown trend. The tide appears to be turning that direction though.

Source: TradeNavigator

It's not an ironclad means of spotting the next major move. As you can see, we got a false sell signal in late October and early November, and these lines were all over the place in June and July. Over time, though -- in a more normal market environment -- the breadth and depth data is quite telling before it's too late to do anything about it.

And it's another red flag that makes the red flags of the breadth and depth trend much more interesting to keep an eye on this time around.

Traders Really Are Ignoring Risks

We've heard it for over a year now, and for over a year it hasn't mattered. That is, stocks are too risky to own. While they've been too risky to own, the S&P 500 has rallied 24%. It's not wrong to say traders have collectively reached a point where they've developed a dangerous level of confidence though, which is usually when the market runs into trouble.

The put/call ratio isn't a tool that's been free of criticisms... some of them deserved, and some of them now. Most of the unmerited criticisms of it, however, were from traders that didn't fully embrace its inherent limitations.

Another short version of a log lesson: The put/call ratio compares the number of bearish put options that trade on any given day to the number of bullish call options that trade the same day. In a normal environment, the ratio is around 65, or about 65 puts for every 100 calls that exchange hands. When that ratio moves well away from that norm, however, it's often a sign traders are reaching a psychological extreme.

The thing about the put/call ratio is, it's a contrarian indicator, meaning when it looks as if traders are exceedingly bearish, it's often a sign of a market top. At the other end of the spectrum, it's actually bullish when the put/call ratio is very high and lots of puts -- rather than calls -- are being bought.

With that as the backdrop, it's alarming that the equity-only put/call ratio for the overall market has reached a multi-year low. Specifically, the 20-day moving average line of the all-equity put/call ratio now stands at 58.2, which it hasn't seen since December of 2014. It's uncomfortably low because traders have put the brakes on much of their put-buying, and are instead just trading calls, assuming there's no need to buy the defense or "insurance" that put options offer.

Source: TradeNavigator

When the market starts to behave in a way it hasn't for a long, long time, clearly something has changed. In this case, the market's psychology has changed in a very peculiar way.

Bottom Line

To head off the arguments before they become arguments, this isn't a call for a bear market. This isn't even a call for a correction, as due as we are. This is simply to point out that some significant but largely overlooked aspects of this rally are changing in a way that inject more risk into stocks than the risks stocks were facing just a few days ago. In the case of breadth and depth, we've seen similar red flags in the recent past, but they didn't matter. As for the put/call ratio, that's a new one. Together, they both should at least give a trader pause about counting on more upside straight ahead.

The frustrating X-factor here, of course, is the fact that we're in one of the market's most bullish times of the year. Even so, we can see the S&P 500 is well beyond the norm in terms of year-to-date gains, even when just compared to the average bullish year.

Source: TradeNavigator

This sets the stage for at least a small pullback in the near future, though not necessarily a big one... and it's still not a guarantee of a near-term correction. Again though, with the put/call trend being where it is and plenty of political turmoil taking shape, the market is ripe for a wave of profit-taking, with plenty of potential catalysts lined up.

With all of that being said, though I'm preparing for the worst and taking some profits on a few of my positions that are a little long in the tooth and/or a little too vulnerable for my taste, I'm not yet convinced enough to commit to an actual bearish trade to make a play on any pullback. I need to see the S&P 500 break under its 50-day moving average line currently at 2577 before I pull that trigger, which will likely be a leveraged bearish ETF trade.

And if you're a true long-term investor and don't care about short-term volatility, none of this means a thing to you except for planning on a pullback in the near future that's ultimately a buying opportunity. It may not happen until January (or even February) though, so don't waste all your holiday time keeping close tabs on the market. If and when it happens, you'll know it. Now you'll know why it's happening.

I might be sharing my specific trading idea mentioned above here at Seeking Alpha. If you'd like to know if, or when, or how I make that play -- which would strictly be a hedge against the rest of my long-term holdings -- hit the "Follow" button above. I'll keep everyone in the loop in the meantime, and offer updated versions of the charts above as they become relevant.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.