Sign, Sign, Everywhere A Sign. But Investors Disregard

If only there were a sign?

Sign, Sign, Everywhere A Sign

“Sign, sign, everywhere a sign
Blockin’ out the scenery, breakin’ my mind
Do this, don’t do that, can’t you read the sign?” – Five Man Electric Band

Over the last couple of weeks, we have discussed the more extreme bullish positioning in markets. In this past week’s 3-Minutes video, we went through quite a few charts showing the same.

Yes, there are certainly a lot of signs. 

On Thursday, SentimenTrader posted a great chart bringing all of this together. 

“For the 1st time in 15 years, 60% of the indicators we track are showing an excessive amount of optimism. An excess of excesses.” – SentimenTrader

In the short-term, the takeaway is that bullish sentiment can, and often does, carry markets further than logic would predict. However, without exception, when “everyone is on the same side of the boat, a reversion will occur. But that is how markets function over time. 

As I discussed previously, the level of speculation in the market is quite rampant as investors have no fear of a market crash. Currently, the speculative call option buying is at a record level, while put buying (a hedge against downside risk) is non-existent. That deviation has pushed the Put-Call Option ratio to a new low.   

Again, this doesn’t mean that a market correction is imminent; however, history shows that such extremes have led to short-term corrections or worse. All that is needed is a “catalyst” to start the selling.

For now, it seems as if there is “no risk.” But it is at these periods, where your “emotional bias” is tugging you away from “logic,” that investors tend to get themselves into trouble. 

However, there is one thing we are watching closely.

The Volatility Signal

In a market that reaches a point of more extreme complacency, it is not surprising to see volatility drop to lower levels. However, it is when volatility becomes more depressed that the contrarian signal becomes more critical. 

As shown in the chart below, the volatility index ($VIX) has troughed where previous mark peaks formed. However, just because a certain level gets reached, it doesn’t mean a correction is immediate. Often, lower levels remain for some time. But, when a “buy signal” is triggered (vertical dashed lines) and volatility turns upward, it has typically been a rapid event.

Also, the volatility signal is more critical when the market becomes simultaneously stretched to more extreme levels. With the market currently pushing a 3-standard deviation extreme from the 50-dma, the stage is set for a short-term correction. 

Notably, that deviation, combined with a negatively diverging RSI (top panel), and more than 90% of stocks above their 200-dma, is a warning. As the vertical lines show, the combination of these measures has previously aligned with market peaks.

 

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