S&P 500 ‘Sudden Drop’ Index at Historic Extreme

The Chicago Board Options Exchange (CBOE), the same outfit that formulated the VIX, also calculates the odds of a ‘two standard deviation decline,’ or large sudden drop. This ‘sudden drop’ index is at a historic extreme.

What is the ‘sudden drop’ index?

It’s the CBOE SKEW Index, calculated by the Chicago Board Options Exchange (CBOE). The CBOE also formulated the SKEW’s more popular cousin, the VIX.

According to CBOE, the SKEW is designed to measure the tail risk of the S&P 500.

What’s tail risk?

Tail risk is the risk of outlier returns two or more standard deviations below the mean. Some call this a ‘Black Swan’ event or simply a sudden drop.

Similar to the VIX, the price of the S&P 500 tail risk is calculated from the price of the S&P 500 out-of-the-money options.

The SKEW typically ranges from 115 to 135. Readings of 135 suggest a 12% chance of a large decline (2 standard deviations). Readings of 115 suggest a 6% chance of a large decline.

What is the SKEW’s track record?

SKEW Index data extends back to January 1, 1990. On June 20, 2014, the SKEW spiked to 143.26, the second highest level in its history.

Is this reason to worry?

The chart below plots the S&P 500 against the SKEW. The red bars highlight prior readings above 135.

Although the highest reading in the SKEW’s history (146.22 on 10/16/1998) did not have any ill effect on the market, the SKEW has been a trustworthy indicator since the beginning of the QE bull market.

According to the SKEW, the odds for a swift decline are near a historic max. However, the bearish SKEW should be balanced with the indicator that foresaw a persistent S&P 500 (NYSEArca: SPY) rally without correction months ago.

A detailed look at this truly fascination gauge is available here:

The Only Indicator That Foresaw a Persistent S&P 500 Rally with No Correction

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.

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

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Two Sentiment Gauges Reach Multi-Year Bullish Extremes

It’s been a while since we’ve seen bullish sentiment conditions, but this week’s rally pushed two sentiment gauges to multi-year extremes. But, there is reason to view the two extremes in context with the larger sentiment picture.

We looked at various sentiment measures in April and May, and the common denominator was that investors were unusually bearish.

As happens so often, bearish sentiment turned into bullish price action (for an insightful read on foolishly bearish forecasts click here: Hey Bears! Where is the Promised Crash or Correction?).

Thanks to the cycle of sentiment mean reversion, rising prices (since late May) lifted bullish sentiment. In fact, two sentiment measures reached multi-year extremes this week.

One particular gauge that foreshadowed a stock market rally back in May was the CBOE Equity Put/Call Ratio.

The May 14 and 18 Profit Radar Report featured this chart of the equity put/call ratio and stated: “Prior corrections were preceded by a put/call ratio around 0.5 or below. Today the put/call ratio is at 0.72, a level that’s indicative of a low more than a top. The equity put/call ratio cautions of further up side.”

The second chart updates the equity put/call ratio and plots it against the S&P 500. On Wednesday the equity put/call ratio dropped to 0.43, the lowest reading sine January 2011.

In addition, the percentage of bullish investment advisors polled by Investors Intelligence rose to 62.2%, the second highest level in the survey’s history.

Readings above 60% generally result in a rally pause or correction. However, the survey’s all-time high water mark (62.9%) occurred in December 2004 and didn’t cause too much trouble.

The equity put/call ratio is more worrisome as it indicates very limited hedging activity. This means many investors are long and naked (long without put protection). If the S&P 500 starts falling, they have to sell their core holding.

I always look at more than just two sentiment gauges. A broadening of the sentiment scope reveals that other gauges are still in neutral territory (retail sentiment, CBOE SKEW Index, etc.).

Once a month, the Profit Radar Report publishes a comprehensive sentiment picture that plots six sentiment gauges against the S&P 500. The May 23 Sentiment Picture proposed that: “The market will grind or spike higher (whichever is necessary to turn more investors into bulls) before delivering a noteworthy correction.”

Clearly the S&P 500 (NYSEArca: SPY) has succeeded in turning many more investors into bulls. Whether it’s been enough to cause a correction remains to be seen, but risk is rising.

What about stock market valuation? Are stocks too expensive and ready for a mean reversion?

Here is an objective look at four different valuation metrics and what they mean for the stock market.

Is the S&P 500 Overvalued?

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.

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

Indicator: Risk of ‘Black Swan’ Event is Elevated

On February 14 we highlighted a ‘big fat’ buy signal. Now we are looking at a possible ‘Black Swan’ alert. This indicator was designed to sniff out big drops and although we may not be looking at a ‘Black Swan’ sell off, it suggests risk is rising.

On February 14, I wrote about a ‘big fat’ buy signal (New Spin on Old Indicator Gives Big Fat Buy Signal).

Now this ‘big fat’ buy signal is met by an indicator that suggests elevated risk of a serious decline (‘Black Swan’ event).

Which indicator measures the odds of a ‘Black Swan’ event?

It’s the CBOE SKEW Index.

The SKEW Index is calculated by the CBOE. The CBOE is also responsible for the VIX (NYSEArca: VXX).

According to CBOE, the SKEW is designed to measure the tail risk (= risk of outlier returns two or more standard deviations below the mean) of the S&P 500.

The SKEW Index basically estimates the probability of a large decline or ‘Black Swan’ event.

Similar to the CBOE VIX or VIX Volatility Index (Chicago Options: ^VIX), the price of the S&P 500 tail risk is calculated from the price of the S&P 500 out-of-the-money options.

The SKEW typically ranges from 115 to 135. Readings of 135+ suggest a 12% chance of a large decline (2 standard deviations). Readings of 115 or less suggest a 6% chance of a large decline.

The chart below shows the SKEW readings since January 2012 and plots them against the S&P 500 (SNP: ^GSPC).

On Friday the SKEW jumped to 138.79. This isn’t the top tick (December/January saw 139.62 and 143.20), but it’s higher than 99.5% of all other readings since January 2012.

The red lines highlight that elevated SKEW readings (such as 138+) translate into limited up side potential and increased down side risk.

The SKEW is very helpful, but should be combined with other facets and forward-looking analysis.

The December 20, 2013 Profit Radar Report (Sentiment Picture) put the message of the SKEW in context with other indicators and forecasted the following:

“Bullish sentiment will catch up with stocks in January. This should cause a deeper, but also temporary correction.”

The S&P 500 and S&P 500 ETF (NYSEArca: SPY) saw a ‘deeper but temporary’ correction and price and SKEW are basically back to where they were in January.

More up side is possible as long as the S&P 500 can stay above support, but the SKEW suggests that the up side is limited and any gains to be erased eventually.

A unique analysis of another popular indicator cautions that the SKEW’s message may be valid:

MACD Did Not Yet Confirm Stocks Up Trend

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.

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

Watch Out! The S&P 500 Just Got ‘SKEWed’

This week the S&P 500 set new all-time highs and got ‘SKEWed’ in the process. Recent history shows that SKEWed for the S&P 500 can mean getting screwed for investors. Here’s what the SKEW is all about.

On Tuesday the S&P 500 rallied to new highs, on Wednesday and Thursday the S&P 500 (NYSEArca: SPY) got ‘SKEWed.’

What’s SKEWed? Is it the same as screwed? It could be.

The SKEW or SKEW Index is calculated by the Chicago Board Options Exchange (CBOE), the same exchange that publishes the VIX (Chicago Options: ^VIX).

The SKEW is an index derived from the price of the S&P 500 tail risk and attempts to quantify the odds of S&P 500 tail risk.

Like the VIX (NYSEArca: VXX), the SKEW is calculated from prices of S&P 500 out-of-the-money options. The SKEW Index basically attempts to quantify the odds of a black swan event (or S&P 500 tail risk).

CBOE identifies a black swan event as a two or more standard deviation move below the mean.

According to the CBOE, a level of 135 suggests that there’s about a 12% chance of a two-standard deviation decline within 30 days. The risk of a two-standard deviation decline drops to 6% at a reading of 115.

In simple terms, SKEW readings around 135 tend to warn of highs or tops, readings around 115 tend to go along with lows or bottoms.

Here’s where it gets interesting.

Yesterday, the SKEW Index spiked to 135.47, the highest reading since March 16, 2012. What happened in March 2012? Not much, but …

The chart below plots the S&P 500 (NYSEArca: IVV) against daily SKEW readings since 2010.

The March SKEW spike didn’t cause any immediate trouble, but starting in April stocks entered a multi-month correction.

In fact, the chart shows that future gains were always given back at some point shortly after the SKEW moved above 134.

Is the S&P 500 screwed just because it got SKEWed?

The high SKEW reading takes on additional significance as the S&P 500 also hit a long-term target and resistance level. The combination between this resistance and the SKEW may well cause trouble.

This key resistance level goes back to the origin of this rally in 2009 and is important. It is discussed in detail here: S&P 500 Hits 2009 Projection Target – Resistance or Springboard?

The Profit Radar Report monitors technical patterns, seasonality and various sentiment gauges and has been looking for S&P 1,760 as target for this rally. Now that sentiment is starting to become frothy, it’s time to become cautious.

Simon Maierhofer is the publisher of the Profit Radar Report.

Follow Simon on Twitter @ iSPYETF or sign up for the FREE Newsletter.

A Detailed Look at 5 Different Sentiment Gauges

If you want to know how much money is waiting on the sidelines to drive stocks higher, take a look at various sentiment measures. Combine those sentiment measures with actual money flow gauges and you’ll get a good idea of how much cash is left (or not) waiting to buoy the stock market.

Seasoned investors look at many indicators before making buy/sell decisions. One of them should be sentiment.

My personal ‘three pillars of market forecasting’ are technical analysis, seasonality, and sentiment.

Technical analysis includes trend lines, patterns (like triangle, head-and shoulders, etc.), Fibonacci levels, divergences and so on.

Seasonality includes seasonal patterns and cycles for broad indexes and sometimes individual stocks and sectors.

Sentiment can be subdivided into many segments. I consistently follow more than a dozen sentiment and money flow gauges and regularly chart the following five for Profit Radar Report subscribers:

CBOE Volatility Index (VIX)
CBOE Skew Index
CBOE Equity Put/Call Ratio
% of bullish advisors polled by Investors Intelligence (II)
% of bullish investors polled by the American Association for Individual Investors (AAII)

The chart below is a reprint of the July 25 Sentiment Picture (available to subscribers of the Profit Radar Report).

It plots the S&P 500  against the above-mentioned sentiment gauges.

The VIX (NYSEArca: VXX) continues to linger near a multi-year low. This has been the case for almost a year. Using the VIX to time market highs has been a fool’s errand. We realized that back in November 2012 when the Sentiment Picture ‘quarantined’ the VIX:

“When an indicator doesn’t work, we’ll put it on ‘probation’ until it proves its worth again.” Let’s just say the VIX has continued to be on probabation.

The put/call ratio is a valuable member of the sentiment family. The May 19 Sentiment Picture noted that option traders were finally jumping on the rally bandwagon and warned that: “Risk is rising. A fair portion of current gains should be quickly retraced.” The S&P 500 (NYSEArca: SPY) quickly lost 7% thereafter before rebounding.

Sentiment polls by Investors Intelligence (II) and the American Association of Individual Investors (AAII) are a ‘casualty’ of the QE liquidity market and need to be taken with a grain of salt.

Extreme bullishness reflected in the polls hasn’t had much of an impact on stocks, but bearish extremes have coincided with rallies.

The April 26 Sentiment Picture for example picked up on the extremely bearish AAII poll numbers and the large number of II folks looking for a correction and wrote:

“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.” In other words: expect higher prices.

It took years of trial and error to become familiar with the various sentiment gauges and learn how to interpret the different readings. I have found that there’s a difference between sentiment polls and money flow indicators. The equity put/call ratio, for example, is an indicator that shows if investers are really ‘putting their money where their mouth (sentiment polls) is.’

When the put/call ratio finally reached extreme territory in May (and investors started to put their money where their mouth is), the stock market turned sour, at least temporarily. A updated chart and analysis of the equity put/call ratio is available here: “Is a Market Top Near? ‘Smart’ Option Traders Send a Curious Message.

Continuous sentiment analysis is available via the Profit Radar Report.

Is a Market Top Near? ‘Smart’ Option Traders Send a Curious Message

Option trader sentiment extremes have racked up a fairly impressive track record as a contrarian indicator in the Fed’s QE bull market. No one else is talking about a major market top, so now might be an appropriate time to ‘check in’ with option traders and see what they have to say.

The QE bull market is 53 months old. The S&P 500 trades 156% higher today than at its March 2009 low, the Nasdaq-100 and Russell 2000 are up 209%.

No one else in the mainstream media is calling for a top, which is all the more reason to open this particular can of worms: Is a market top near?

One specific segment of traders has offered valuable clues about approaching market tops in the past: Option traders.

Equity Put/Call Ratio

The Equity Put/Call Ratio and SKEW Index capture the actions of the kind of option traders considered ‘dumb money’ (please don’t shoot the messenger, I didn’t come up with the term).

The Equity Put/Call Ratio shows the put volume relative to call volume. A ratio above 1 occurs when put volume exceeds call volume. The ratio is below 1 when call volume exceeds put volume.

Puts are bought to protect portfolios against declines; calls are bought as a bet on higher prices.

Since this is a contrarian indicator, high readings (0.9 or above) are usually seen near market bottoms when fear of a decline runs high. Readings around or below 0.5 reflect a dangerous extent of complacency and occur near market highs.

Last week the Put/Call Ratio fell as low as 0.55%. What does that mean?

The chart below plots the S&P 500 (NYSEArca: SPY) against the equity Put/Call Ratio (bottom of chart) and the SKEW Index (more about the SKEW in a moment).

The vertical red lines highlight readings at market tops.

When viewed in the context, the current Equity Put/Call Ratio is approaching a level that’s caused trouble for stocks in the past.
This note, which I sent to subscribers on April 16, 2010 explains exactly why: “The put/call ratio 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 accrued 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.
This note preceded the 2010 ‘Flash Crash’ by only 13 days.
The current reading doesn’t foreshadow a Flash Crash, but a degree of caution is warranted.
SKEW Index
Like the VIX, the SKEW is calculated by the CBOE. The SKEW is far less popular than the VIX, but has delivered much better signals than the VIX lately.
The SKEW Index in essence estimates the probability of a large decline. Readings of 135 suggest a 12% chance of a decline. Readings of 115 suggest a 6% chance of a large decline (large decline is defined as a two standard deviation move).
In other words, low extremes are bullish for stocks; high extremes are bearish for stocks.
As the chart shows, the SKEW is currently in ‘bullish for stocks’ territory.
This contradicts the more or less bearish message of the Equity Put/Call Ratio.
What do we make of this?
Past experience has taught me not to bet against the SKEW. It’s prudent to allow for higher prices, perhaps after a shallow correction.
To get the best possible read on the stock market, I look at sentiment (such as options data and other sentiment/money flow gauges, seasonality and technical signals.
Right now the technical picture for the Nasdaq-100 (Nasdaq: QQQ) is fairly crisp and clear. The Nasdaq-100 is moving towards serious resistance in a well-defined trend line channel. This resistance increases the odds of a sizeable top dramatically.
Simon Maierhofer is the publisher of the Profit Radar Report.
Follow Simon on Twitter @ iSPYETF

 

Bullish vs Bearish Indicators – Who Has the Upper Hand?

Recent articles highlighted various individual indicators. Some were bullish, but the majority was bearish. This article reviews previously discussed signals and boils them down to one outlook.

In recent weeks we’ve examined various indicators, studies, gauges and seasonality. Some bullish, some bearish. But what is the balance? Does the weight of evidence suggest higher or lower prices?

Listed below is a summary of articles designed to help form an educated and balanced opinion. Articles are categorized as bullish or bearish based on their implications. >> click here to view all the links to prior articles.

Bearish:

April 23: Dow 16,000! Headline Indicator Sways Into Bearish Territory
Barron’s Big Money Poll delivered the most notable sentiment extreme in 2013. Professional investors’ record bullish outlook is bearish for stocks.

April 17: Did ‘Sell in May and Go Away’ Arrive Early?
Based on consistent seasonality, the March 31, Profit Radar Report suspected a mid-April and May double top. The mid-April high is in and the ‘double top’ appears to be in the making.

April 16: From Gold Glitter to Jitter: An Explanation for Gold’s Historic Decline
Falling precious metals prices often foreshadow weakness for stocks.

April 10: Bearish Buying Climaxes are Adding Up for Stocks and Even the S&P 500
Buying climaxes are a sign of distribution, which is bearish for stocks. Discussed in detail was a buying climax in particular for the S&P 500. The most likely outcome was a delayed (1-2 weeks) decline, which is what occurred.

April 4: Yield Spread Between Junk Bonds and Treasury Bonds Hits Alarming Level
The ‘risk on’ trade has reached a level that’s caused trouble in the past.

April 1: AAPL, GOOG, AMZN and MSFT – Tech Sector Giants Turn Laggards
The lagging behavior and lack of leadership by ‘Big Tech’ suggested that the rally is starting to run out of steam.

Bullish/Neutral:

April 17, Profit Radar Report: “There are open chart gaps at 2,850 for the Nasdaq-100 (and 1,588 for the S&P 500). In recent years all chart gaps have acted as magnet and the Nasdaq-100 (and S&P 500) should come back to close those gaps. We’ll close our short positions at 2,740 – 2700 (and around S&P 1,540).”

April 19: Weekly ETF SPY: Russell 2000 ETF – IWM
The Russell 2000 and S&P 500 bounced off major support. That’s bullish … as long as support holds.

April 17: Despite Extreme VIX Movements, Option Traders are ‘Lukewarm’
Option trader sentiment has established a solid track record as contrarian indicator. Contrary to the deeply complacent readings of the VIX, other option-based indicators (like the SKEW index) aren’t even close to bullish extremes.

April 11: Retail Investors Turn Record Bearish as S&P 500 Climbs to All-time High
The most volatile of sentiment gauges fell to a bearish extreme. Viewed in isolation that’s bullish for stocks, but only viewed in isolation.

The April 17 VIX/SKEW article summarized the overall situation as follows:
“To an extent, option-trader sentiment is in conflict with other bearish sentiment extremes discussed recently. When sentiment indicators conflict, technical analysis and support/resistance levels become even more valuable.”

Technicals highlighted key resistance at 1,593 and key support at 1,538. As per the Profit Radar Report, we went short the S&P 500 once the S&P 500 dropped back below 1,590 (April 12) and covered our short positions at 1,540 and 1,562 (April 18 and April 22).

Based on the weight of evidence, there will be a short windon with a low-risk opportunity to go short.

How to go short with minimal risk is revealed in the Profit Radar Report.