Tuesday, August 14, 2007

Touching Base with the PCEVXO

Given the current state of volatility, many market participants believe that the while the volatility indices are printing some extreme numbers, these are somewhat mitigated by the rather mild moves in various put to call ratio data.

Of course, it depends upon which data you are looking at. If you examine at the CBOE’s equity put to call ratio, you see that equity put volume set a new single day record back on 7/26 and the ratio itself peaked on 8/1. The ISEE shows more persistent put buying that did not peak until 8/7.

I have previously mentioned the PCVXO in this space, an index developed by Jay Kaeppel that combines the put to call and volatility data into one aggregate indicator. While I have no problem using the VXO, which is highly correlated to the VIX (as the OEX is to the SPX), I prefer two alternatives to Kaeppel’s recommended put to call ratio. Kaeppel uses the total put to call ratio, while I strongly prefer the CBOE’s equity put to call ratio or the ISEE. For the sake of clarity, I will refer to my refinements of the PCVXO as the PCEVXO and ISEEVXO, respectively, going forward.

Enough with the nomenclature. What are these indicators telling us?

Looking at the PCEVXO, it printed an all-time high on 8/6 and has been extremely overextended ever since, resulting in a very strong bullish signal for the markets. Not surprisingly, the VXO component of that indicator set new records on 8/9, 8/10 and 8/13. For comparison purposes, the PCE portion of the indicator set a new record on 8/6 and has been dropping slowly ever since. Interestingly, given the magnitude of the VXO readings, the divergence between the record VXO and merely very high PCE has also been at an all-time high for the last two sessions. As discussed back in May, when there is a strong divergence, this is also a bullish signal.

In summary, while you should never ignore all the red numbers on your screen, volatility and put to call data indicate that the current situation is the best contrarian buying opportunity during the four years for which there is PCEVXO data. That being said, stops and protective puts are always a good idea, particularly in skittish markets.

I suspect that those who are profiting from fear and panic can keep up the negative news flow through Friday’s options expiration. After that, the back to school sale should be over.


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