The US stock markets have enjoyed an awesome run
since late August, with the flagship S&P 500 stock index (SPX) up
23.7%. Traders have earned huge
profits in sectors that leverage general-stock-market gains, including
commodities stocks. But as usual
after any long and uninterrupted rally, complacency reigns supreme
today. Such sentiment is a prime
breeding ground for spawning corrections.
Nearly all short-term price movements are driven by
the collective emotions of traders.
When they feel good, they buy stocks. And rising prices eventually lead to
greed. When they feel bad, they
sell stocks. And falling prices
ultimately spark fear. These two
emotions are perpetually warring, swinging back and forth like a great
pendulum. Greed dominates when
prices are up, then fear flares when they are down.
Complacency is a close relative to greed. It is “a feeling of quiet
pleasure or security, often while unaware of some potential
danger”. Like greed, complacency
grows when prices are high. The
conditions that generate it are long, uninterrupted rallies leading to big
gains. After the stock markets rally gradually
for months without retreating, the
majority of traders start assuming the risk of a selloff has vanished.
But this is always a foolish assumption, as all
markets flow and ebb. Bull markets advance forward two steps
before retreating one step in their periodic selloffs. Far from being bad, these retreats are
extremely beneficial for traders.
They rebalance sentiment, bleeding off excessive greed and
complacency. This extends the
life of the bull market, as it will burn out prematurely if greed sucks in
too many traders too quickly. And
they drag prices back down, creating the best buying opportunities seen in an
ongoing bull.
The more years you spend trading stocks as a student
of the markets, the easier it becomes to recognize the excessive complacency
that leads to stock-market retreats.
It manifests universally in the things the financial media reports,
the way analysts and traders view the markets, and how smug everyone becomes
about the current rally continuing indefinitely. As an example, this week on CNBC I
heard a professional money manager forecast “a 24% gain in the S&P
500 during the next 100 trading days”!
While the subjective read on the collective emotions
dominating the markets is incredibly valuable, it takes many years to develop
the experience necessary for this skill.
Thankfully there are hard objective
indicators that betray extreme complacency. When they get to certain levels, the
odds of an imminent retreat balloon dramatically. All traders can watch these indicators
as warning signs preceding retreats.
I will explore several of my favorites in this
essay, the VXO implied-volatility index, the SPX bullish-percent index, and
the put/call ratio. My charts
this week superimpose the last couple years of S&P 500 action (its
current cyclical bull)
over these key sentiment indicators.
As I suspect you’ll agree after digesting this analysis, given
these indicators’ positions today probabilities heavily favor an SPX
retreat.
I use the word “retreat” to encompass
both pullbacks and corrections, which have specific definitions in the stock
markets. Pullbacks are retreats
in the major stock indexes running less
than 10%, while corrections are larger retreats weighing in at more than 10%. Provocatively given the extreme states
of these sentiment indicators today, it is increasingly likely a full-blown
SPX correction looms.
Let’s start with the premier sentiment gauge,
the VXO. It was the original
old-school VIX before that index was heavily modified in September 2003. Technically the VXO measures implied
volatility in at-the-money options, expiring 30 calendar days out, for the
elite S&P 100 stock index.
This index represents the top 20% of the S&P 500 companies, the
biggest and most-liquid stocks trading in the US. During any material stock-market
selloff, these are the companies sold first, fastest, and most. They can readily absorb huge volumes,
letting traders exit quickly with minimal adverse price impact.
Despite the new VIX’s popularity with the
financial media, the original-formula one (now VXO) remains a much purer
measure of sentiment.
Today’s VIX was diluted by adding the lower 80% of SPX stocks,
which are much less liquid and hence less responsive in major selloffs. It also includes a broader range of
short-term options, including out-of-the-money ones that are also less
responsive to market moves.
In the VXO, high levels reflect heavy volatility and
extreme fear. We saw epic VXO extremes during 2008’s
once-in-a-century stock panic.
Volatility and fear was off the charts. I used the VXO to call the major SPX
bottom early in March 2009
leading into today’s bull.
Conversely low VXO levels reflect greed and/or complacency. And as this chart shows, the VXO has
recently ground down to some of the lowest levels seen in this entire stock
bull since the panic.
A month ago on December 22nd, the VXO slumped to
14.37 on close. And then again
last Friday, it fell to 14.36. As
the red VXO line shows, these are very
low levels relative to the past couple years. The only other times the VXO has even
come close to today’s levels were back in April 2010 (14.26) and
January 2010 (16.49). And look
what happened to the blue SPX line immediately after these reads.
The US stock markets as measured by the flagship
S&P 500 saw major interim highs right
at those previous VXO lows!
After last January’s low VXO reading indicating extreme
complacency, the SPX promptly fell 8.1% over the next 14 trading days. While still in pullback territory
(less than 10%), this was the biggest retreat seen in this entire cyclical
bull to that point. Traders
caught unaware got slaughtered.
And then again last April the SPX peaked right when the VXO hit the same levels
we’ve seen in recent weeks.
Complacency was so out of hand then that the SPX needed a full-blown correction to rebalance
sentiment! The stock markets
ultimately plunged 16.0% in 49 trading days, their first correction-magnitude
decline of today’s cyclical bull.
Once again smug traders who didn’t expect such a selloff were
crushed.
These periodic selloffs are such a big deal because
their impact is leveraged in hot sectors like commodities stocks. Losses in the large commodities stocks
during major SPX selloffs often amplify the broader stock markets’
declines by 2 to 1 or more. So a
15% SPX retreat, a garden-variety correction, can easily lead to losses
approaching a third in a matter of
weeks for big commodities stocks!
And smaller more-speculative ones often fare even worse. So gaming
these periodic retreats is critical for traders.
If you can read sentiment and anticipate such selloffs before they happen, you can realize the
gains on your existing trades near the preceding interim highs. This builds up cash balances which are
the perfect way to weather a pullback or correction. After the retreats run their courses,
you can then buy back in to your old trades or launch new trades with a lot
more bang for your buck (your same capital can buy many more shares).
So seeing the VXO back down in the danger zone from
which the biggest pullback and only correction of this entire cyclical bull
were born is a huge warning sign.
Traders have to understand that no matter how great everyone feels
about the markets today, the odds overwhelmingly favor a serious
selloff. Complacency is just too
extreme, and since the markets abhor extremes they are never sustainable.
The second indicator to consider is the SPX’s
Bullish Percent Index. It reveals
what percentage of the 500 stocks in this index currently show buy signals in their point-and-figure
charts. Point-and-figure charting
is an interesting relic from the dark days before the Information Age. Easily done by hand, it didn’t
require computers and spreadsheets.
It shows rising prices as columns of Xs and falling prices as columns
of Os.
These charts are fascinating because they distill
out the effects of time. Each point-and-figure column can
represent one day or many days, within the same chart. Not showing time in the usual linear
fashion offers some unique insights into trends that normal price charts
can’t reveal. While this
makes point-and-figure charting confusing at first, it is a rigid discipline
with well-defined rules. For BPI
purposes, any stock’s chart always shows either a point-and-figure buy or
sell.
There is no ambiguity.
Like most sentiment indicators, BPIs are contrarian. You want to buy stocks when other
traders are the most scared, because that is when prices are lowest. And you want to sell when others are
the most greedy or complacent, because prices peak then. So a high SPX BPI reveals extensive
bullishness, hence greed and complacency, in the stock markets. These are the times to sell and await
a retreat.
Just this week the SPX’s bullish-percent index
soared to 87.4, meaning 87.4% of the elite 500 stocks in this flagship index
were showing point-and-figure buy signals! Note that this is well into the danger
zone that marked the major interim highs before the biggest pullback and only
correction of this entire cyclical bull.
Last January before that big 8.1% pullback, the SPX BPI peaked at
83.2. And in April before that
16.0% correction, it hit 87.2.
Today once again the SPX BPI is right at these dangerous levels.
When stocks have been bought for so long that
everyone thinks they are going to continue higher indefinitely, all near-term
buyers have already been sucked in.
So once some minor catalyst sparks any selling, there is little
capital left to buy stocks. The
unimpeded selling soon feeds on itself, scaring more and more traders into
exiting their positions.
Super-high SPX BPI reads reveal these topping conditions.
There appears to be an exception to this rule back
in September 2009. The SPX BPI
soared to 88.6 then, a more extreme reading than today, yet the stock markets
only retreated 4.3% in a mild pullback.
So why couldn’t we face a similar minor retreat today based on
precedent? It is important to
remember that 2009 was a very atypical year emerging out of the panic-driven
extreme lows. Many sentiment
indicators bounced all over the place as the preceding anomaly quickly worked
its way out of the system.
The farther that crazy panic recedes into the
rearview mirror, the more the stock markets are returning to normal behavior
patterns. And in normal times like
now, extremely high SPX BPI reads almost always precede major pullbacks or
corrections. I certainly
wouldn’t want to bet against this well-established sentiment indicator,
its historic track record is excellent.
Finally take a look at the put/call ratio, which
measure the relative balance in the options markets. When traders expect the stock markets
to rise, they buy calls. These
give them the right to buy stocks at a certain price for a certain period of
time. When traders expect the
markets to fall, they buy puts.
These let them lock in a selling price today for months into the
future. Like most sentiment
indicators, the PCR is contrarian in nature. When do traders buy the most calls and
puts? At exactly the wrong times!
Traders tend to crowd into calls after a long
uninterrupted rally. They
extrapolate the market gains out into infinity and assume the buying will
persist indefinitely. Since calls
are the denominator of the PCR, a low PCR reading (more calls than puts)
signals one of these major interim highs. Meanwhile traders prefer puts after a major selloff, again expecting
it to continue. So the PCR peaks
during major corrections, when traders are the most scared and expect the
stock markets to fall the farthest.
Since traders’ collective sentiment can vary
wildly from day to day, the raw put/call ratio is extremely volatile. To make it easier to analyze, I use a
21-day moving average to smooth out some of these wild spikes. This is effectively a 1-month average,
since calendar months average 21 trading days. Once again, this third sentiment
indicator reveals extreme complacency today. Traders
fear no selloff at all!
In recent weeks the PCR 21dma has fallen as low as
0.766. Traders are buying far
more calls than puts, because they expect the stock markets to continue to
rise. This read is deep into the
danger zone that marked major interim highs before the biggest pullback and
only correction of this cyclical bull.
Early in last January’s 8.1% pullback, the PCR 21dma hit
0.769. And it slid to 0.786 a few
days into that 16.0% correction that started after April’s major
interim high.
Because of the moving average applied to this
indicator, it tends to lag slightly (a week or so). But this isn’t a problem since
the PCR downtrends are already well-established before it enters its danger
zone warning of an imminent major stock-market retreat. If you watch this indicator every day
as we do, you know where it is heading before it gets to the point where the
odds of a selloff ramp towards certainty.
After digesting these three charts, see why I
strongly suspect that an SPX correction looms? Complacency is extremely high as
measured by the venerable VXO.
The stock markets have essentially rallied nonstop since late August
with just a single minor 3.9% pullback in November, so traders have forgotten
about the ever-present selloff risk.
Their relentless buying has driven the vast majority of SPX stocks
into point-and-figure buy-signal patterns, a telltale signature of major
interim highs.
And options traders feel the same way as stock
traders, expecting the markets to continue rallying in a straight line
indefinitely. They have been
aggressively buying calls, betting on rising prices. Meanwhile relatively few have bought
puts, either to hedge existing stock positions or actively speculate on a
stock selloff. The markets have
been rallying for so long that few expect puts to pay out anytime soon.
Yet indeed this week the SPX’s correction may have already started. As always though, sadly most traders
will be caught unaware. They will
suffer serious losses in their stocks in sectors that amplify the stock
markets’ moves. Even worse
they will get scared before this correction ends, which will lead them to do
most of their selling at the absolute worst time near the bottom rather than
now near the SPX highs.
Recognizing the increasing risks of major pullbacks
and corrections before they arrive
is one of the great benefits of studying the markets. It enables you to sell high which maximizes your realized gains. It also gets you back into cash which
is the ideal way to ride out a serious selloff. Later you can use this cash to buy
back into positions near the bottom at bargain prices, starting the whole
trading cycle anew.
At Zeal, we’ve long been shepherding our
subscribers through the big risks and subsequent great opportunities of
corrections. Earlier this month,
we sold a half-dozen commodities-stock trades in our
flagship Zeal Intelligence
monthly newsletter. Their average
annualized gains ran +136.0%! As
January marched on and the sentiment reads got even worse, we liquidated 7
more commodities-stock trades in our weekly Zeal Speculator
newsletter. These trades averaged annualized realized gains of +180.3%!
When your passion is studying the markets, and you
trade for a living, all that hard-won knowledge and experience really pay off. I certainly understand that most
traders don’t have the time or inclination to study the markets all day
every day for decades. But there
is no reason why you can’t still reap the fruits of all these
labors. Since we’re going
to do our research anyway to support our own trading, we also sell it in the
form of popular newsletters and fundamental stock reports. (The latest is on silver stocks.)
Our subscribers aren’t surprised by
corrections, as we show them what to expect and how to maximize the trading
opportunities selling events create.
Our subscribers learn to suppress their own greed and fear and see the
markets with cold rationality, empowering them to sell high when everyone
else is greedy and buy low when everyone else is scared. Since 2001, all 231 stock trades in Zeal Intelligence alone have averaged
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Subscribe today and
start thriving in the markets!
The bottom line is the key sentiment indicators are
screaming that an SPX correction looms.
The stock markets have simply been running higher for too long without
interruption, so complacency has grown to extreme proportions. This is never sustainable,
the markets abhor any emotional extreme and soon move the other way to
rebalance sentiment. As always,
traders caught unaware will suffer serious losses.
But there is no need to be surprised, as very
specific and measurable conditions precede major pullbacks and
corrections. Astute traders who
watch for these can sell into strength just before the correction, maximizing
their realized gains and protecting their capital in cash through the
subsequent selling. And then they
are perfectly-positioned to buy the resulting bargains near the bottom. Corrections should be embraced, not
feared, as they offer the best buying opportunities in any ongoing bull
market.
Adam Hamilton,
CPA
Zealllc.com
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Adam? I would be more than happy to address them through my private
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more information.
Thoughts,
comments, or flames? Fire away at zelotes@zealllc.com.
Due to my staggering and perpetually increasing e-mail load, I regret that I
am not able to respond to comments personally. I will read all messages
though and really appreciate your feedback!
Copyright 2000
- 2006 Zeal Research (www.ZealLLC.com)
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