Global Markets Technical Outlook Video September 2014

Heres the latest video covering the technical outlook for major global stock markets, currencies and commodities (45 minutes).  Click screen to play.

Sentiment Indicators at Extremes

Let the trend be your friend is an often quoted maxim in the trading and investing world, and it would be an unwise market participant indeed who chose to stand in the way of the blistering uptrend we have witnessed in the US stock market of late.  However, whilst making hay while the sun shines, its also useful to be cognisant of when market conditions might be reaching a point of climax, and as we take a look at two important indicators of sentiment, its just possible we could be nearing such a time.

Firstly the VIX, which is the Volatility Index tracking future implied volatility on S&P500 options.  As the market continues relentlessly higher, there is less demand for options, especially on the Put side the principal method of insuring a stock portfolio against market falls.  This fall in demand translates to lower implied volatility and hence a lower VIX.  A low reading in the VIX is in effect a sign of complacency by market participants. Importantly though, implied volatility is mean reverting, meaning when it reaches an extreme (either high or low), it will tend to reverse back towards its long term average.

Looking at the chart below, we can see that the VIX has been trending lower ever since the last major correction in 2011, whilst the S&P500 (lower pane) has been moving ever higher.

Click for up to date chart

Looking at a long term chart of the VIX (below), we can see that the levels were now seeing in the VIX are at historic lows, and levels that have not been seen since the pre-Financial Crisis market highs in 2007.

The VIX has only been below 11 on 1.8% of days since 1990, and has only closed below 10 on 9 days since 1990.  So, its fair to say the current level of 10.32 is at an extreme low, and that we will eventually see a reversal higher (ie stockmarket moving lower) from this area.  However, this extreme low reading in and of itself doesnt give us any information about the timing of any reversal.  As you can see, the VIX can stay at low levels for extended periods.  However, there is a second sentiment measure, which may provide a better clue to reversal timing

The Put/Call Ratio measures the ratio of open Put contracts to open Call contracts in the equity options market.  When the stock market is trending strongly upwards, there will be more buyers of Calls than Puts, driving this ratio lower, and so it shares an inverse relationship with the market.  This is also a mean reverting measurement and will tend to sharply reverse from extreme highs or lows.

As you can see, the last two major corrections in the US market in 2010 and 2011 were both preceded by extreme low readings in the Put/Call Ratio, and currently at the hard right edge of the chart, we are approaching similar levels.  This is indicating the risk of a stock market correction increasing towards a high probability in the near term.  If were looking for likely catalysts for a reversal, one possibility is when and if the S&P500 hits the psychologically important 2000 level, where it could meet strong resistance.  Its currently only 15 points short of that level now.

Of course, the US stock market is in a very strong long term overall uptrend, so any sell-off that does eventuate in the short term, is likely to be followed by a resumption of the uptrend, and a market correction may actually provide low-risk medium term long side entry opportunities.  In the meantime though, with the market starting to look overheated, it could be time to take care of our number one job as traders and investors managing portfolio risk.

Happy Trading!

This website and its articles are for educational use only.  No content in any way implies a recommendation to buy or sell any financial instrument, nor is it financial advice.  Trading and investing in financial markets carries considerable risk, and you should always consult a licensed financial advisor to confirm whether any investment is right for your circumstances.

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