Risk Off Gauge That Correctly Signaled 2000 and 2007 Top is In Freefall, But …

Twice in 2014 we looked at the XLY:XLP risk on/risk off ratio for clues about the market’s next move. Twice the XLY:XLP ratio pointed us in the right direction. Now it’s pointing lower, which contradicts an even more powerful indicator.

The ratio of two diametrically opposed asset classes often provides insightful clues about what investors are doing.

The XLY:XLP ratio is one such example.

Unlike many hypothetical indicators, the XLY:XLP ratio is an actual money flow indicator, based on what investors are doing, not saying or thinking.

XLY represents the Consumer Discretionary Select Sector SPDR ETF. XLP represents the Consumer Staples Select Sector SPDR ETF.

The XLY:XLP has offered some excellent signals and tell tale signs both long-term and short-term.

Long-term:

A breakdown of the XLY:XLP ratio correctly signaled the 2000 and 2007 market tops.

Short-term:

We looked at the XLY:XLP ratio twice this year.

The first time was on May 20, when it was at the verge of breaking down.

The conclusion back then was that there were simply to many bears to drive the S&P 500 down.

The second time was on August 7, when the XLY:XLP ratio rose despite an S&P 500 selloff (see chart below for dates).

The conclusion was that the XLY:XLP ratio rally actually reduced the risk of an immediate stock market decline. The S&P 500 rose steadily for the next 90 days or so.

This time around the picture looks different, as the ratio has broken below long-term trend line support. This suggests that the time of shallow, V-shaped corrections – so prevalent throughout 2013 and 2014 – is over.

Another 2000 or 2007-like Top?

Does this breakdown also foreshadow another bear market, like it did in 2000 and 2007.

Context may be key here. The 2000 and 2007 market tops were also preceded by an even more important sell signal (more about this signal in a moment). This signal hasn’t triggered yet convincingly.

Furthermore, a close-up look at the XLY:XLP ratio since 2008 shows two prior trend line breaks (2012 and 2013, red circles) that turn out to be false signals. Unlike the 2001 – 2007 move, the post 2009 rally has been quite choppy, testing and breaking support more frequently.

The XLY:XLP ratio by itself is telling us that there is potential for further losses, but as the 2012 and 2013 breakdown reversals show, any correction may hit rock bottom without notice.

Looking at the ‘Big Guns”

As mentioned above, another indicator that not only foreshadowed the 2000 and 2007 market tops, but also predicted that every correction since 2009 would lead to new highs, has not yet given a convincing sell signal.

The indicator is probably the most valuable gauge for any investor at this moment.

It is discussed in detail here: 3 Strike Wall Street Law – QE Bull Market Only One Strike away From Knock Out

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, 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.

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Assessing QE Bull Market Longevity Based on Investor Sentiment

The Federal Reserve’s liquidity policy has changed the game. Those who don’t adjust to the new rules will become dinosaurs. The interpretation of sentiment indicators is one of the things that changed. Changed yes, but obsolete no.

Is investor sentiment still a valid contrarian indicator in the Fed-manufactured liquidity rally?

The short answer is yes, but …

But what?

I believe that investor sentiment (as contrarian indicator) is an important piece of the puzzle of the market-forecasting picture, but it needs to be recognized that QE has altered money flow and how investors feel about stocks (NYSEArca: VTI).

The QE domino effect changes how sentiment should be used and interpreted.

Here’s the value sentiment indicators bring to the table in a QE market. See if you can find a pattern.

Excerpts are taken from the monthly Sentiment Picture, published by the Profit Radar Report:

The beginning of 2013 saw some slight sentiment poll extremes, but actual money flow indicators reflected indifference. In other words, investors didn’t ‘put their money where their mouth’ was.

This changed in May. The May 19 Sentiment Picture noted growing optimism, particularly among money flow indicators, and warned that: “Risk is rising and the tipping point where the market is running out of buyers is nearing.”

For easy comparison, the S&P 500 (SNP: GSPC) below shows S&P 500 daily bars along with Sentiment Picture forecasts.

The S&P 500 corrected after the May Sentiment Picture and came back to new highs on August 2.

The August 18 Sentiment Picture focused on whether the August 2 high marked a major market top and concluded that: “A major August top is possible, but not probable.”

The S&P 500 (NYSEArca: SPY) rallied to a new high in September, and the September 27 Sentiment Picture asked if the September high marked a major top?

September 27 Sentiment Picture conclusion: “Although current sentiment doesn’t preclude lower prices, the lack of bullishness at the September highs suggests higher prices ahead eventually.

The chart below shows the actual September 27 Sentiment Picture (without the commentary). The S&P 500 is plotted against five different sentiment gauges to provide a comprehensive sentiment analysis.

It shows the VIX (Chicago Options: ^VIX) near the lower end of the range. But that’s meaningless. Various 2012 Sentiment Pictures put the VIX (NYSEArca: VXX) on probation since it has lost its contrarian indicator mojo.

The other four gauges (CBOE Equity Put/Call Ratio, SKEW Index, % of bullish advisors and % of bullish investors) showed no notable extremes.

The October Sentiment Pictures (forgive me for keeping this chart exclusive for Profit Radar Report subscribers) shows an obvious up tick in bullishness, especially for the SKEW Index and the percentage of bullish investors.

Previous bullish extremes weren’t enough to trigger a market top call. Is last week’s significant up tick enough?

The companion article to the subject matter of sentiment addresses this question:

Do Current Sentiment Extremes Allow for Another 20% Rally?

Simon Maierhofer is the publisher of the Profit Radar Report.

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New Indicator by Stanford University Measures Media Sentiment

Astute investors have commented on the contrarian correlation between the media’s take on the stock market and the stock market’s performance. Now there is an actual index that keeps a pulse on the media’s sentiment.

Stanford University constructed a new index that gauges media sentiment.

I’m a ‘headline junkie’ and couldn’t wait to chart the raw data of the university’s Equity Uncertainty Index. Here’s a thumbnail rundown on the index:

Equity market related uncertainty is measured through an analysis of new articles containing terms related to equity market uncertainty. Terms are subdivided into three ‘theme buckets.’

1) Uncertainty or uncertain.
2) Economy or economic.
3) Equity market, equity price, stock market or stock price.

To be included by the index, an article must include at least one word of each bucket.

Searched are about 1,000 newspapers (via a NewsBank database) throughout the United States. Newspapers include large national papers like USA Today and small neighbor papers.

The number of newspapers NewsBank covers increased from 18 in 1985 to 1,800+ in 2008. To adjust for the growth, the index normalizes the results to an average value of 100.

Interestingly, according to the University, the index has a contemporaneous daily correlation with the VIX (Chicago Options: ^VIX). The data and Equity Uncertainty Index goes back to 1985.

As the chart below shows, the index is rather noisy, even when illustrating the 30-day simple moving average (SMA). Of course, it’s always tricky to cram 28 years of data into a five-inch chart.

The second chart cleans up the Equity Uncertainty Index a bit and plots it against the S&P 500. For this chart we’re looking at the 90-day median average since the year 1999.

Now we are starting to see a basic correlation between media reporting and stock market action. As with most sentiment indicators, the media’s reporting bias is deeply contrarian.

Big spikes in ‘uncertainty’ – much like the VIX ‘fear’ Index (NYSEArca: VXX) – generally mark a major market bottom.

Complacency, or the lack of uncertainty can (but don’t have to) be trouble for the S&P 500 (NYSEArca: SPY) and the broad market.

I look at headlines every day and compose my very own, non-scientific media index.

For example, below is my observation published in the March 10, 2013 issue of the Profit Radar Report:

“The Dow surpassed its 2007 high and set a new all-time high last week, but investors seem to embrace this rally only begrudgingly and the media is quick to point out the ‘elephant in the room’ – stocks are only up because of the Fed. Below are a few of last week’s headlines:

CNBC: Dow Breaks Record, But Party Unlikely To Last
Washington Post: Dow Hits Record High as Markets are Undaunted by Tepid Economic Growth, Political Gridlock
The Atlantic: This Is America, Now: The Dow Hits a Record High With Household Income at a Decade Low
CNNMoney: Dow Record? Who Cares? Economy Still Stinks
Reuters: Dow Surges To New Closing High On Economy, Fed’s Help

We know this is a phony rally, but so does everyone else. We know this will probably end badly eventually, but so does everyone else. The market likes to fool as many as possible and it seems that overall further gains would befuddle the greater number. Excessive optimism was worked off by the February correction. Sentiment allows for further gains.”

Looking at the chart, we see that the media is somewhat, but not extremely complacent.

I wouldn’t use this indicator as a timing tool, but it’s a fun study and potential warning.

Other sentiment and money flow indicators on the other hand are very powerful and have correctly foreshadowed market tops and market bottoms. With stocks at all-time highs we’re scouting signs for a market top.

This article is long enough already, but you may check out what other sentiment and money flow indicators ‘say’ about the potential for a looming market top. Here is: A Detailed Look at 5 Different Sentiment Gauges

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF

Sentiment: Risk is Rising As Correction Concerns Are Fading

Investors have been expecting a correction since the last and steepest leg of the rally started in mid-April. Surprise! There hasn’t been a correction in over a month and investors are starting to think there won’t be one. It pays to stay alert when most become complacent.

When buyers become scarce prices fall. This facet of the supply/demand principle applies to every market, including the stock market.

How can you monitor the supply of buyers? There is no foolproof way, but investor sentiment and money flow data are a good gauge.

The Profit Radar Report consistently monitors dozens of different sentiment and money flow stats and publishes a broad summary every month (called the Sentiment Picture).

This year’s sentiment readings have been the most schizophrenic I’ve ever seen.

It started in February when sentiment polls conducted by Investor’s Intelligence (II) and the American Association for Individual Investors (AAII) registered extreme readings. Those extremes, however, were not confirmed by actual money flow indicators (such as the option put/call ratio, margin debt and money invested in bullish vs bearish funds).

The February 15, Sentiment Picture drew that conclusion: “Investors may not be putting their money where their mouth is.” Money flow discredited bullish sentiment readings and suggested further up side.

The media is another contrarian indicator that falls into the sentiment category. There is no media index, but if you study the headlines every day you develop a feel for media sentiment.

The March 10, Profit Radar Report noticed that: “The media seem to embrace this rally only begrudgingly and is quick to point out the ‘elephant in the room’ – stocks are only up because of the Fed. Below are a few of last week’s headlines:

CNBC: Dow Breaks Record, But Party Unlikely To Last
Washington Post: Dow Hits Record High As Markets Are Undaunted By Tepid Economic Growth, Political Gridlock
The Atlantic: This Is America, Now: The Dow Hits A Record High With Household Income At A Decade Low
CNNMoney: Dow Record? Who Cares? Economy Still Stinks
Reuters: Dow Surges To New Closing High On Economy, Fed’s Help

We know this is a phony rally, but so does everyone else. We know this will probably end badly eventually, but so does everyone else. The market likes to fool as many as possible and it seems that overall further gains would befuddle the greater number. Excessive optimism was worked off by the February correction. Sentiment allows for further gains.”

The April 26, Sentiment Picture (chart below) noted that: “36% of advisors and newsletter writers polled by Investor’s Intelligence (II) are looking for a correction. Incidentally, that’s exactly what we are expecting. However, the market rarely fulfills the expectation of the masses. A bullish surprise is possible.”

Market is Getting Hot, But Correction Talk is Getting Old

The percentage of advisors waiting for a correction has since dropped to 26% and a widely featured Reuters article exclaimed that “Correction talk gets old as rally sails along.”

As the media, investors, and newsletter writers are starting to discount the odds for an upcoming correction, we should become more alert and less complacent.

More importantly, there’s been a notable shift in money flow indicators. Investors are now actually putting their money where their mouth is. This is significant. Why?

There is a tipping point where there are simply not enough buyers left to push prices higher. Where is that tipping point?

The brand new Sentiment Picture for May (published by the Profit Radar Report) shows exactly how close various sentiment and money flow indicators are to their tipping point.