3 Contrarian Signals Flashing Red AlertDec 13, 2012
Chad Karnes, CMT
The market has rallied off its November lows and Santa Claus is delivering. But, there are sentiment warning signs that the market's upside is likely limited.
A skeptic is defined as someone not convinced something is true and requires evidence to validate claims made by others. In the world of investing, a contrarian falls into this category. Count me as a big one.
There are many tools available to a contrarian to help identify times a market is ripe for a trend change. Three of these contrarian signals are flashing sentiment warning signs now.
#1 – Implied Volatility is (once again) Very Low
The VIX (CHICAGOOPTIONS:^VIX) is one tool that measures fear and complacency in the markets. When complacency is high, the VIX is low and markets are typically toppy.
Over the last five years the VIX has spent less than 5% of its time below the 16 level. The majority of the time the VIX spent well above 20. Today it is once again below 16. (VIDEO: Financials: More than Meets the Eye)
The chart below shows some of the analysis included in our Newsletter and Technical Forecast and shows why a new bull market is likely not right around the corner.
Bull rallies do not typically start when the VIX is at these low levels. Market (NASDAQGM:QQQ) selloffs however do. The black vertical lines identify VIX lows below the 16 level that also happen to almost always coincide with a market top of some sort. Virtually every time the VIX has fallen below 16, a market top was near and the VIX rallied at least a few points.
With its price once again around 16, the VIX is providing a great price to hedge your portfolio through VIX call options, market put options, or other forms of hedging through short term trades on VIX ETPs such as the VXX (NYSEARCA:VXX) or UVXY (NYSEARCA:UVXY). To learn about some of the risks in trading volatility exchange traded products see my article entitled “The good, the bad, and the ugly in trading volatility."
#2 - Dumb Money Remains Long
In spite of the fiasco with MF Global, The Commodity Futures Trading Commission does a great job at providing useful data for investors, especially contrarians.
The Commission provides a breakdown of the “Smart” money and the “Dumb” money based on classifications between hedgers or speculators. Over the long run the hedgers are usually on the winning side of the trade and the speculators the losing side.
Despite the snapback rally the last month (NYSEARCA:SPY), hedgers remain net short and support a contrarian sell signal.
#3 – Actual Volatility Reeks of Complacency
In another sign of complacency, the actual volatility of the markets provides clues as to its future performance. When actual volatility is low (as opposed to implied volatility that the VIX measures), complacency among participants is high. As the market’s (NYSEARCA:IVV) actual volatility lowers, traders and investors “let their guards down” so to speak, and that is when bears attack.
The above chart shows the S&P (SNP:^GSPC)at top with the market’s actual volatility based on its daily trading range at the bottom. When price starts to move less than 10 points each day (identified by the vertical black lines), the market (NYSEARCA:DIA) is typically close to a topping point.
There are 11 examples of this occurring since 2010 and all but one have resulted in the market giving back all of its gains and then some once the signal is triggered. Market prices are very close to this level of complacency right now at 10.4 average points moved per day and likely will trigger this or next week.
Those who don't learn from the past are doomed to repeat it!
The ETF Profit Strategy Newsletter combines technical, fundamental, and sentiment analysis to formulate high probability profit strategies. We publish a monthly Newsletter along with a twice weekly Technical Forecast to help our subscribers identify warning signs, like complacency, and better navigate the markets.Follow us on Twitter @ETFguide