Wednesday, August 12, 2020

Investors Need To Turn the Heat Down Before the Market Boils Over

By Rick Pendergraft

(Editor’s Note: Over the next few weeks the League of Power will be running a special and timely series from master trading expert Rick Pendergraft. You may recognize Rick from his numerous appearances on CNBC, Bloomberg and Fox Business News.  While the markets are soaring Rick’s analysis is showing we may be entering a rather precarious place for investors. If you currently have money in the market that you’d like to protect, click the confirmation link in your email newsletter version and to make sure you receive these alerts.)

A few nights ago I was boiling some potatoes, intending to make mashed potatoes as part of my family’s dinner. I got them peeled and chopped, threw them in the pot, turned the heat on high, put the lid on and walked away. I got on my computer and started running some closing numbers on the market and got distracted. The hissing sound of the water boiling over and hitting the hot burner quickly got my attention again and I ran to the stove and turned the heat down to a simmer.

This isn’t the first time this has happened to me, but this time something besides the potatoes popped into my head. The pot boiling over reminded me of the stock market. When there is too much heat (too much optimism), the pot (market) is bound to boil over (sell off) eventually.

The market has been on a great run over the last three months with the S&P gaining ground in 11 of the last 13 weeks which equals one quarter. During this time, the index has gained almost 12%. Unfortunately this rally has also put the index in overbought territory on a weekly and monthly basis. The weekly chart below shows the rally.

Down at the bottom of the chart we see two different overbought/oversold indicators—the 10-week Relative Strength Index (RSI) and the Slow Stochastic readings. It isn’t important that you know how the two indicators work, but it is important that you know what constitutes overbought on each of them. On the RSI, the 70 level is considered overbought while on the Slow Stochastic indicator, 80 is considered overbought.

While these technical indicators alone might be enough to cause concern, they aren’t the biggest problem in my opinion. The bigger problem comes from the sentiment indicators. The sentiment indicators measure the amount of optimism toward the overall market and two of them are showing extreme levels of optimism right now.

The first one is the Investors Intelligence report which is a survey of investment newsletters. The report is released each Wednesday and it simply shows a bullish percentage and a bearish percentage. The two numbers never add up to 100% and the missing percentage should be considered as neutral investors.

The Investors Intelligence report from February 6 showed a bullish percentage of 54.7% and a bearish percentage of 21.1%. This would leave a neutral percentage of 24.2%. The important part of this report is the ratio of bulls to bears. If we take 54.7 and divide it by 21.1, we get a ratio of 2.59 bulls for every one bear.

After years of watching this indicator, I can tell you that this ratio is sending a warning sign to investors that they need to turn the heat down. When optimism gets too high, the market tends to come under selling pressure shortly thereafter. Does this mean we are in for a bear market? Not necessarily. Does it mean you should rush out and sell everything? I don’t think so.

The second sentiment indicator that has been hitting historic levels is the CBOE Volatility Index (VIX). The VIX measures the volatility in the options market of the S&P 500. This is another one of those indicators that you don’t have to understand how it is calculated; you only need to know how to read it. I don’t know how electricity works, but I know how to flip the switch and turn on a light.

The VIX is commonly referred to as the fear gauge of the market with high readings meaning investors are fearful and low readings indicate that investors are confident, or complacent at the very least. A weekly chart of the VIX shows how trips down below the 15 level have not been all that common over the last five years.

To give you an idea of what has happened when the VIX has been below the 15 level over the last few years, I re-did the S&P chart and market each time the VIX dropped below 15 on the chart with a red arrow.

This doesn’t exactly instill confidence toward the overall market does it? The market has been in a long-term uptrend during this entire period, but when the VIX has hit 15, the market has experienced some serious pullbacks.

When you combine the low VIX reading with the high ratio on the Investors Intelligence report, you can see why I am worried about the market boiling over. Now add the overbought levels being reached by the S&P on the weekly and monthly charts and you have numerous reasons to exercise caution in the coming months.

To me, sentiment analysis is just as important as the fundamentals and the technical analysis. When you combine the three of them, you can find some great opportunities.

If you would like to learn more about how to use sentiment indicators to improve your investment results, be sure to check out my upcoming F.A.S.T. Trading System. Don’t be fooled by the name, F.A.S.T. is an acronym only. It isn’t day-trading, but it also isn’t a buy and hold system. It uses the Fundamental Analysis, Sentiment and Technicals to find the best opportunities in the market.

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Rick Pendergraft

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