The 3 Worst Pieces of News So Far in 2014

2014 is still young, but some of the very recent developments have the potential to be more than quick glitches and really ding the economic recovery and derail the stock market rally.

2014 hasn’t exactly started off with a bang for stocks.

The S&P 500 and Dow Jones are in the red so far and there’ve been three down right negative and unrelated news items.

1) According to FactSet, 94 out of 107 companies on the S&P 500 that have issued an earnings outlook for the fourth quarter have fallen below Wall Street consensus. This 88% ‘over promise’ rate is the most pessimistic reading since FactSet started tracking the data in 2006.

2) The official U-3 unemployment rate fell from 7% to 6.7% in December. How is that bad news?

Unfortunately, U.S. employers added only 74,000 jobs in December while 347,000 ‘workers’ left the workforce. For every 1 person that found a job, 5 people left the workforce.

The chart below plots the S&P 500 (NYSEArca: SPY) against the unemployment and labor force participation rates.

In a normal environment the participation rate and unemployment rate do not move in the same direction, just as the cost of living and ones disposable income do not move in the same direction (if one goes up, the other goes down and vice versa).

3) The ‘dumb money’ is getting foolishly giddy about stocks. This data point is not a poll, it’s an actual money flow indicator.

Sometimes there’s a discrepancy between what investors say (polls) and what they do (money flow). Investors not “putting their money where their mouth is’ existed for much of 2013.

Not so now. This indicator shows a clear commitment to stocks with very little fear. This indicator is close to a reading that preceded the 2010 Flash Crash, which shaved 1,000 points off the Dow Jones (DJI: ^DJI) in one day.

The chart that shows exactly how concerning this extreme reading is, along with a fascinating nutshell analysis, can be found here: Flash Crash Indicator Nearing Flash Crash Signal

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (stocks, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Flash Crash Indicator Nearing Flash Crash Signal

Somewhat unwittingly I actually predicted the 2010 Flash Crash, which caused a 10% one-day drop. The same indicator that triggered a warning signal before the Flash Crash is inching closer to Flash Crash Territory.

The greater fool theory on Wall Street requires that the ‘dumb money’ buys from the ‘smart money’ at the top.

This implies that a ‘dumb money’ rush into stocks tends to precede some sort of down market.

Are there enough ‘great fools’ buying right now to trigger a down market, nasty correction or even flash crash?

Admittedly somewhat unwittingly (say that ten times fast) I predicted the 2010 Flash Crash using the CBOE Equity Put/Call Ratio.

The Flash Crash happened on May 6, 2010 and saw a 102-point one-day drop in the S&P 500 and 1,010-point drop in the Dow Jones.

In a special alert to subscribers on April 16, 2010 (now called the Profit Radar Report) I warned of the following:

The message conveyed by the composite bullishness is unmistakably bearish. The put/call ratio in particular can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses occurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

We are now again in an environment where the option put/call ratio has been steadily declining for weeks.

A number of media outlets have discussed the bearish message of the currently low equity put/call ratio.

As with any indicator, the current put/call ratio needs to be viewed in context with the bigger picture. The chart below does just that.

The first chart plots the S&P 500 against the CBOE Equity Put/Call Ratio (daily data and 10-day SMA). The vertical dashed red line on the left marks the Flash Crash.

Four years of daily put/call data comes with a lot of noise.

The second chart plots the S&P 500 (NYSEArca: SPY) against the same data, but filters out some of the noise by separating the daily and 10-day SMA put/call data.

The daily put/call ratio dropped to 0.46 on 12/31 and 0.47 yesterday, which means call volume was more than twice put volume. This doesn’t happen often and has lead to corrections in the past.

The 10-day SMA put/call ratio was at 0.512 on Wednesday, the lowest reading since January 2011. Back then it didn’t affect stocks immediately, in fact the market kept moving higher (albeit not in a straight line) for three more months before giving back all gains and then some.

Three weeks before the Flash Crash, the 10-day put/call SMA fell as low as 0.445.

The Flash Crash on May 6 was a result of bullish enthusiasm and lacking put protection as explained above.

Is a Flash Crash possible in early 2014? It’s possible, but unlikely.

But it doesn’t take a Flash Crash to eat into profits. A garden-variety correction can do the same thing Chinese drip torture style.

Another data point shows that ‘Mom and Pop’ are piling back into stocks, which enhances the bearish message of the put/call ratio.

The biggest lesson of 2013 is not to sell indiscriminately just because sentiment becomes overheated.

Throughout 2013 the Profit Radar Report continued to anticipate higher prices despite elevated sentiment levels. Only in recent weeks sentiment has reached levels indicative of increasing risk for longs.

Nevertheless, to get a sell signal in this QE market we need to see extreme bullishness (which we now have) and a drop below support. To repeat: Only bullishness AND a drop below support = Sell signal. This combination is so powerful I call it ‘insider trading.’

Here’s a look at how this kind of ‘insider trading’ works and where key support for the Dow Jones is right now. Insider Trading Just Became Legal

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (stocks, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE iSPYETF Newsletter to get actionable ETF trade ideas delivered for free.

Buying Climaxes Soar to ‘Flash Crash’ High as 30% of S&P 500 Stocks Peak

Buying climaxes are at the highest level since April 2010. The April 2010 highs were closely followed by the May ‘Flash Crash.’ Are the current conditions similar to 2010 and should we be concerned about a ‘Flash Crash-like’ event?

There were 864 stock buying climaxes last week. What is a buying climax and why is that significant?

Buying climaxes happen when a stock (or index) makes a 12-month high, but closes the week with a loss. They are a sign of distribution and indicate that stocks are moving from strong hands to weak ones.

iSPYETF previously pointed out elevated buying climaxes in articles published on February 13 (112 buying climaxes) and April 10 (347 buying climaxes).

Both instances were followed almost immediately by corrections (see chart). Last week’s number of buying climaxes – 864 – eclipses the 112 and 347 climaxes seen prior to the February and April corrections.

In fact, the current reading is the second highest total since 2004 and is surpassed only by the 1,079 buying climaxes in the week of April 30, 2010 (see chart insert).

It sounds dramatic, but it’s worth pointing out that the April 2010 price high was chased by the May ‘Flash Crash.’

Does that mean another ‘Flash Crash’ event is around the corner?

The ‘Flash Crash’ was preceded by historic sentiment extremes and an incredibly concerning equity put/call ratio. In an April 16, 2010 note to subscribers (now known as Profit Radar Report) I warned that:

The equity put/call ratio is 45% below its six-month average. The message conveyed by the composite bullishness is unmistakably bearish. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

Current conditions aren’t as extreme as they were in April 2010, but they should be of concern to investors, nonetheless.

It doesn’t take a ‘Flash Crash’ to hurt a portfolio. A slow and determined correction can do the same thing ‘Chinese drip torture-style,’ – slower, more painful, but with similar results.

Like in 2010, it will take a ‘watershed’ event, a decline that spooks enough investors, to get the ball rolling.

A break below important support will likely be just such an event. The Profit Radar Report already pinpointed the must hold support level that – once broken – will lead to lower prices.

Despite Crazy Run and New Highs, Immediate Flash Crash Unlikely

The S&P 500 is up 15% since mid-November, while the Dow rallied to never before seen highs. Something that’s just too good to be true with a wink-of-the eye implication that another Flash Crash type event is brewing. What are the odds?

What goes up must come down. We’re all aware of this fact of life. The question is, when will stocks come down and how fast and far will they come down?

There’s been some talk about another Flash Crash event, so I wanted to check out how likely another Flash Crash-like event is right now.

The price action leading up to the May 6, 2010 Flash Crash is illustrated in the first chart below.

Note that the ominous May 6 sell off happened eight trading days after the April 26 high. By the time May 6 rolled around, the S&P 500 had broken below two support levels (green lines). It also broke out of a triangle formation.

The basic recipe of events (time lag between top and waterfall decline, break below support levels) also led up to Black Monday, the fateful day that saw stocks crash in 1987.

Another clue leading up to the 2010 high was an extremely low equity put/call ratio. In a note to subscribers on April 16, I warned of the following:

“The message conveyed by the composite bullishness is unmistakably bearish. The put/call ratio in particular can have far reaching consequences. Protective put-buying provides a safety net for investors. If prices fall, the value of put options increases balancing any losses occurred by the portfolio. Put-protected positions do not have to be sold to curb losses. At current levels however, it seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling results in more selling. This negative feedback loop usually results in rapidly falling prices.”

The equity put/call ratio is currently in neutral territory and the S&P 500 just posted a new top tick yesterday. The S&P would have to drop below initial support at 1,540 first. This would have to be followed by a break below key support.

The time lag between a new high and break below support should give investors enough time to turn defensive.

Seasonality suggests that the time for a Black Swan sell off is not (yet?) ripe. ‘Sell in May and go away’ has been a good strategy in most recent years, especially in 2010. March/April seasonality is not nearly as bearish as May.

In summary, the risk of an immediate Flash Crash type event is negligible, but that doesn’t mean that prices will only go up.

The potential for a Black Swan event and larger decline becomes greater if we zoom out of the very near-term into the mid-and longer-term timeframe.