One of the ways for us to understand the emotional state of the markets is to look at sentiment. The spectrum of fear and greed is wide, and when we tally up all the different indicators, from VIX to put/call ratios and from polls to money flows, we generally wind up near the middle of that spectrum.
At least, that is true in the long term. In the short term, we see anxiety, stress, and uncertainty. The recent rise in volatility is understandable; there are many uncertainties out there (the Ebola virus is a prime example).
What’s really worrisome is the speed at which these moves are occurring. Everyone seems to “know” this market rally has gone too far and too long (cue the sarcasm), yet every time we hear, “This is the end!” the markets turn right back up again. I have to give the market the benefit of the doubt for now, but I’ll be honest: This recent activity has me concerned about that trend continuing.
Things feel the same as they did prior to other downturns – drops are sharp, swift and massive. I suspect at some point that the irrational cries of “sell it all” will fade, but when? If the charts and technicals show too much damage, there will be resistance that is difficult to overcome.
However, if we look at the markets from 30,000 feet, we can see that some major extremes were reached on Thursday and Friday. The disconcerting part is how quickly they occurred. Will the old adage, “Markets go up on the escalator and down through the window” hold true here?
For answers, let’s take a look at sentiment indicators and their readings from an objective point of view, match them up with the charts, and see where we may be headed.
I always like to start with the VIX, or annualized 30 day volatility. This indicator has moved up to levels not seen since February, a more than 90% move higher from late August. I won’t get into the reasons for the move here, because any reason is good enough to hit the sell button and/or buy protection.
When the “buy the dip” crowd failed to materialize last month (on a few occasions), there was a market vulnerability. The good news, though, is the VIX is sitting in rarefied air at the moment. See this chart of spot VIX and the term structure, along with this chart by Steve Place of investing with options, which shows the VIX/VXV ratio and how unsustainable a ratio over 1 has been since late 2012.
The put/call ratio has been showing the fear just as well as the VIX. The total put/calls have recently hit some very high readings – a 21 moving average over .90, which is quite rare but augers a potential for a BIG rally when it turns back down.
My good friend Larry McMillan says that when this turns lower and moves under .90, it is a very strong signal that predicts a 100 handle move in the SPX 500. (It is still rising, so any buy here is far too premature.) Further, we saw equity put/call ratios over 1 on three occasions this week, also another rare event. So, while not completely washed out yet, this indicator is as stretched back as far as possible.
Other indicators that I’m looking at are the CNN fear/greed poll, which came in Friday with a ONE! I’m not sure if it can go negative or to zero, but we’ll soon find out! Investor polls are also trending toward a more defensive posture as well, with the American Association of Individual Investors (AAII) seeing a recent upswing in bears and their weather vane moving toward the bearish side. These are all coincidence indicators, which show sentiment in the moment; they are only secondary in trying to estimate the next move.
Finally, the McClellan Oscillator clocked in at some pretty extreme numbers Friday – the Nasdaq reading is -169 while the NYSE reading is a staggering -195. We’ve seen lower readings, of course, and when they coincide with a “That is enough!” mood, most investor get whipsawed. The rubber band is stretched back far, and it has been for a month.
Bottom line: The ingredients are in place for a sharp snap back WHEN the selling subsides.
I won’t stick a hand in and try to catch a falling knife – and neither should you. Wait for things to settle down and pick your spots carefully. I don’t believe the markets are set up for a fall here, they’re only down 5% from the highs, but these drops are happening REALLY fast and it just feels bad – especially with continued support from the Fed until the economy and unemployment are on safer ground.
