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Beware the Little Guy...


Since when was a little optimism such a bad thing?


Trying to discern how people feel about markets is a difficult chore, prone to subjective "analysis" and a whole host of psychological biases, not to mention hard to find – or outright bad – data.

But by being a little more rigorous, we can sometimes find opportune periods when being aggressively positioned long or short can work well. We had one of those times in August.

At the time, I pointed out a few of the indicators of panic that had jumped on my radar, and how it was likely that we'd see positive returns going forward. Now that many market indices have cycled back up to or beyond their old highs, those signs of pessimism have melted away and the past few days have seen a rapid expansion in the number of indicators showing the precise opposite condition – too much optimism.

One way to track that is by watching what the very smallest of options traders are doing with their money. This is not an opinion poll, it is actual money being committed to a leveraged, decaying instrument – perfect for monitoring sentiment, since people become more emotional when they're trading something like that.

The chart below shows what the smallest of options traders have done with their money over the past few years, and the red circle shows last week's value. The indicator is created by determining how much volume is spent buying speculative call options versus protective put options, which a high reading indicating too much optimism and a low reading too much pessimism.

Click here to enlarge.

Last week, small traders spent 47% of their volume on speculative calls, betting on further upside. Only 16% of their volume went to buy protective puts. That 31% difference eclipsed any other reading I've seen during the past several years, and indeed you'd have to go back to 2000 to find anything more extreme.

Based on the previous extremes as shown on the chart, that doesn't seem very comforting, and I'm toning down my expectations in response. The average return over the next couple of weeks in the S&P 500 (^SPX) after past extremes was negative, and higher-beta indices like the Nasdaq 100 (^NDX) or Russell 2000 (^RUT) often fare significantly worse, so I'll be watching closely for signs of potential weakness as we enter earnings season.

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No positions in stocks mentioned.

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