The market has been going through a few changes over the last month, changes that you need to watch.
We.ve watched the post-election rally turn into a sideways trading market as a little bit of excitement around the market has worn off.
We’re starting to hear analysts talk about how President-elect’s policies are going to result in a fresh wave of inflation in 2025.
We’re seeing companies lower their earnings guidance for the next quarter or two as it appears the Board Rooms are preparing for a slowdown of their own.
Should you worry?
The answer is simply “yes”, at least for the next few months.
Let’s look at three reasons why investors should be nervous about this market and a few simple steps you can take to prepare for what may be a bumpy January and February.
You’re not going to read about investor sentiment anywhere else the way you will here. I’ve been covering this form of analysis since 1998 and have learned the major triggers you need to watch.
Investors have been overwhelmingly bullish for much of 2024. Much of that comes from the fact that the Fed is lowering rates and is likely to continue.
Investors celebrated the outcome of the election as the process resulted in a clear winner. That removed a lot of potential uncertainty from the market causing investor sentiment to become even more bullish.
But there’s always a tipping point. That point when investors get too optimistic. Whether you’re a died in wool contrarian investors or a simple fundamental investor, you understand that those tipping points are dangerous for the market.
We’re at one of those points right now. Wise investors are putting their plans together right now.
Let’s take a look at the situation and how to prepare.
The CBOE Volatility Index – or simply “The VIX” is one of the most effective sentiment indicators out there.
The VIX is a measure of expected volatility that comes from the options market.
The calculation and how the readings are derived are complex, but the end-use of the VIX is simple.
High readings of the VIX indicate that the options market is operating in “Fear Mode”. Two things make options traders fearful, volatility and lower prices. When those two things start to happen, the VIX climbs.
The reverse is true. Low volatility and high prices result in low readings of the VIX. Options traders just don’t feel the need to buy protection when things are calm.
But there’s a catch, low readings of the VIX are often the calm before the storm.
We saw this in July. Readings of the VIX dropped to a reading of 12 before starting to move higher. The VIX then started trending higher signaling that the options market had now shifted into fearful selling.
The S&P dropped 10% after that low reading of the VIX and the VIX is starting to look like it did in July again.
Last week, the VIX hit a low of 12.50 before starting to move higher. Watch for two or three closes above 15 to signal that the market is ready for a July Style pullback of 10% or more as we head into the end of the year.
Investor’s Intelligence is a widely-followed sentiment indicator. The poll itself measures the percentage of bullish, bearish, and neutral opinions among financial newsletter writers and advisors.
Just like the VIX, the Investor’s Intelligence poll is used to gauge when investors have become too bullish or bearish.
Every week, the number of bullish responses is compared to the bearish responses by putting the numbers into a ratio. Readings above 1.0 indicate that there are more bulls than bears, which is natural.
What isn’t natural is when the number of bulls outweighs the bears by a ratio of 3.5 or more.
When the readings get above 4.0, it becomes what we refer to as a “rare” signal that investors have just gotten excessively optimistic.
Excessively high readings, usually 4.0 or higher (denoting that there are four bulls for every bear) signal that investors are too optimistic and that the market is likely to suffer a correction.
This week’s reading of the Investor’s Intelligence Bull/Bear index is 3.91. We’ll call that close enough to say that investors should be on guard for a correction.
Like the VIX, the Investor’s Intelligence Bull/Bear ratio signaled a correction in July when the ratio went above 4.0.
One of the simplest sentiment indicators out there is the CNN Fear & Greed Index.
The index takes readings from seven different indicators that represent market sentiment – including the VIX – and represents current market sentiment in the form of one number.
Today, that number is “Neutral”, which feels good compared to the other sentiment indicators we’ve talked about.
But there’s a catch.
This indicator tends to signal early and then takes a long time to shift to a “buy” signal.
For example, the CNN index flashed an “Extreme Greed” signal in April and then didn’t turn bullish until after July’s 10% correction.
To that end, the index flashed an “Extreme Greed” reading just over a month ago.
With two of the three sentiment indicators flashing warning signals, investors would be wise to consider that the market is setting up for a fast and possibly aggressive correction.
The S&P 500 chart concludes two different pullback scenarios.
First, a short and painless drop of just 3% to the S&P 500’s 50-day moving average. That bullish trendline is more than strong enough to act as support for the broad market index.
But a 3% pullback isn’t enough to clear out the overwhelming optimism currently priced into the market.
This is one of those markets that would benefit from a deeper 10% drop.
10% corrections are referred to as a “Healthy Correction” for a reason.
They clear out the bandwagon investors and open opportunities for long-term investors to “buy the dip”.
The S&P 500’s 200-day moving average currently sits at 5,500, about 9.7% below current prices. This is the level that investors should consider a good buying point as stocks would have reset with a healthy 10% correction during one of the weaker seasonal periods of the year.
