Technical Tuesday: Market's Screaming "SELL PREMIUM!"

There are two exceptionally reliable indicators that are telling you to expect a pullback soon.  But if not, expect some sideways action.

The first indicator, which is the RSI, is one I told you about two weeks ago in my article titled “Profit If S&P is Within a 4.6% Range.”

The S&P 500 is actually exactly where it was when I wrote that article, which means if you followed that trading idea, you’re making money on it. 

I’ll get back to the RSI in a second. 

But first let me point to the Investor’s Intelligence Advisor Sentiment Index

This is an indicator created by polling over 100 advisors and well known newsletter writers and charting the percentage who are bullish and who are bearish (and who are neither — just looking for a correction before buying). 

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It’s a contrary indicator, only useful when readings are in extreme territory as they are today.  If the reading shows that advisors are overly bullish, it’s actually a sign of a near top, and vice versa. 

Let’s take a look…

To begin simply, understand that the top half of the following chart is the S&P 500 and the bottom half shows the percentage of bullish advisors (red line) and the percentage of bearish advisors (blue line). 

Bullish readings above 55% are considered to be overly bullish territory and suggest caution.  As the reading gets closer to 60, a sharp correction becomes more and more likely.  But the bullish reading hardly ever actually gets to 60 before the market pulls back.  The red flags go up when we are over 55.

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But there’s another way to view this data.  Notice how low the blue line has gotten.  While the percentage of bullish advisors is currently at 55.20, the percentage of BEARISH advisors is as low as 15.60.  

That low level of bearishness has only been seen twice in the last 10 years: 

  • At the 2011 May high (right before the mini crash caused by the U.S. credit rating downgrade by S&P) before the S&P 500 declined over 21%.
  • Right before the January-February 2010 sell off of 9.2%, leading up to the “flash crash” a few months later, which was a 17% decline.

(See blue line at bottom of chart below)

Advisors Sentiment Index – 10 Year Chart

** Always remember:  No indicator is 100% accurate. They are just “indicators“. And in a 10-year chart, like the one above, a few months of time passing (as prices continued higher in some cases) can appear, on the chart, to have happened in the blink of an eye.  So study the chart closely and think about that.  While there are many occasions where the market did correct immediately after an overly bullish reading, there are times when the market said “Damn the iceberg!  Full speed ahead!

So far we have looked at the percentage of bullish advisors and the percentage of bearish advisors.  Before I show you the last way to view this data in comparison to the stock market, take one last look at the bullish readings in the 10-year chart, above.

I drew a horizontal red line to show the 55 level, and I drew a bunch of vertical red lines to show you other times when the reading got to 55%.  Sometimes it continued higher with market prices.  Sometimes it almost made it to 55 before correcting, at which point I drew black lines up to the S&P 500 chart. 

But now I’ll show you the final way to view this data, and it might surprise you.  Notice that the red and blue squiggly lines expand and contract.  They contract when there is fear in the market (fewer bulls and more bears) and they expand when there is complacency (more bulls and fewer bears).  So we can benefit by charting the difference between the two readings. 

Subtracting the percentage of bears from bulls is useful because, as you may notice above, while the bullish readings touched the 55 mark a few times in the chart, the bearish readings were different at each one of those points. 

Below is a 1-year chart showing the difference between bulls and bears.  Currently the difference is 39.6 percentage points!  That’s a huge difference.  It shows excessive optimism.  Can you say “Madness of Crowds“?

So what does a difference of 39.6 suggest?

Instead of just reading technical analysis history books and accepting a static rule on the levels considered extreme, or times to exercise caution, it makes sense to consider the more recent norm.  Let’s look for some historical context here.

You may have noticed in the 10-year chart, way above, and the 10-year chart, below, that investors seemed to be less reluctant to take a bullish stance prior to the 2008 disaster.  So a reading of 40 seems to me to be even more overly bullish today than a reading of 40 in, say, 2006.

No matter which way you slice it, pre-2008 or post-2008, the 39.6 reading we are looking at right now is a dangerously bullish level that tends to coincide with market tops.  Thus, it makes sense to be cautious here and for intermediate-term to long-term investors to start selling or reducing or hedging positions by selling premium, using options. 

Markets can stay overbought for a long time.  When they are oversold, they tend to snap back up very quickly, but they take 3 times as long to top out.  Overbought signals are typically not emergent, which is a positive as long as you’re using the opportunity to lock in some gains or tighten up your stop loss orders.  In fact, times when markets are overbought are often when the biggest winning stocks tend to make their biggest gains (buying climaxes).  Is that what you’ll wait for?  To try to time that?

Add to that the fact that we are in the bullish season, November – January, when the stock market statistically makes the biggest gains!

So it can be frustrating to sell covered calls to collect premium only see your gains reduced or to see your stock get called away.  Heck, this could turn into a total stock market price orgy where the world is on stock market ecstasy with prices continuing to blast higher.  But that’s the classic mindset near market tops.  Investors become more concerned about missing more gains than they are about seeing a price decline.

Hey, it’s still the first half of November.  The seasonality effect doesn’t mean we can’t see a 5% correction in here before a strong rally brings prices back up.  And while a 5% correction sounds like an easy road to ride, you may own individual stocks that would get punished much worse than that, so inspect your portfolio and consider the details.

Back to the RSI…

In closing, I’ll review the RSI, a momentum indicator that I discussed two weeks ago when I suggested selling premium to take advantage of the likelihood that the S&P 500 would trade sideways.

Similarly to the the Advisors Sentiment charts above, I drew red lines from time when the RSI put in an overbought sell signal.  I skipped the first one in 2013 for a good reason.  After the RSI bottoms out in overSOLD territory (late 2012) it sort of “resets”.  And once it resets, the first RSI sell signal is typically ignored and the early RSI sell signals are often not as potent as the later sell signals. 

The bottom line is, we have an extreme reading in the Sentiment Index and an overbought sell signal in the S&P 500’s RSI.  2013 is set to be one of the strongest years in recent history. 

Most investors didn’t get a chance to participate for the most part because of diversification away from the stock market due to leftover fear from 2008 (believe it or not).  And as is conventionally believed to be the responsible thing to do, most Investment Advisers have their clients diversified in a mix of stocks, bonds, commodities, cash, currencies, real estate products etc. etc. etc.  This reduces your returns relative to the strongest asset class in the world right now, the U.S. stock market.

Heck, even the average hedge fund is underperforming the stock market. 

But once again, that’s a classic psychological trap that investors fall for near market tops.  And at the risk of appearing to be foolish in the eyes of readers whose very nature it TYPICALLY is to only have a short-term memory, I refuse to tell you what you want to hear.  After all, we are talking about a contrary indicator — one with a reliable history (historically, most readers suggest I’m an idiot when I talk about this and they do occasionally seem to be correct for a period of time, but if you study the charts and consider that I write about this any time we get to the extreme readings, you’ll understand how that played out… But most people forget by then).

I have no idea how long the LONG-TERM BULL MARKET will last.  I’m not calling the next bear market here.  But I am reiterating caution, the opportunity to sell calls against your bullish positions to collect premium, an account review to see which laggards should be pruned from your portfolio, and possibly some position size reduction. 

As you may have read, the accounts I control have both bullish as well as bearish positions on at all times in order to reduce the directional bias of the stock market and focus instead on the outperformance of various asset classes, countries and industries versus one another. 

I hope this helps!  Trade safe!

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