In the previous article a few major indicators were presented that show the stock market is overbought and may be headed for a pullback or correction. The market have gone up near 75% since the 2008 crash and 10% over the past year. Surveys of traders and investors all read bullish with fewer participants bearish. This bullish outlook among the majority has no doubt helped lead to the rally we have had, but could things be coming to at least a temporary halt?
The VIX is an indicator used by professional traders, hedge and mutual funds, and money managers. It attempts to measure complacency or fear in the markets. For this reason is is also known as the ‘fear index’, and it can actually be traded. When bullishness climbs and people buy stocks fear resides. Risk trades are said to be on. The VIX will show this as a declining value on its chart. When fear starts to climb and people are starting to sell their stocks the VIX will rise. So from that standpoint it is an inverse indicator.
On the Barons Roundtable last week all the analysts were bullish. Wall Street is amok in bullish commentary, and you can find bullish articles everywhere (even mine last week). But know that as techncial traders we trade the trend until the trend changes and then we trade that. Even knowing that things are getting over extended to the bull side does not mean it will change tomorrow; just that risk is getting higher.
Barry Rithholz on CNBC’s Fast Money program expounded all the above and said he thinks the market is headed into its last ‘quartile’ of rally. A technical chartist frequently on the progam gave 1280 as a ‘predicted’ top for the S&P 500. (We are now closing in on that.)
Does this mean the overbought internals that suggest a pullback only create conditions for a pullback now and a correction comes later? No one will know until either happens. The markets can stay irrational longer than any of us can stay solvent as it has been said by a former Federal Reserve Chairman.
Some conjecture has been made about the January earnings season providing a catalyst in either direction. We found out this morning that the economy grew at 2.6% the third quarter.
The VIX can be used to help determine if the market has reached a top. As pointed out with the indicators shown in yesterdays article sentiment indicators work at extremes. They attempt to show when things may be running out of steam in either direction and market conditions are ready for a reversal.
Unfortunately or fortunately, depending on your use of this information, we as humans are doomed for the most part with a herd mentality. We can be like the herd of deer that has been spooked and begins running in the direction until they are clear of the danger or exhausted.
The chart in this article shows the VIX for the recent period and the S&P 500. You can see when the VIX has declined to the 16 area the market has fallen back. This has occured several times on this chart. The VIX as you can see is now again in the 16 area.
You can also see that each decline was not equal. You cannot tell from the VIX how far a pull back or correction may go and indeed some declines were corrections and others just over due regular pull backs.
So will the VIX be right again in forecasting a market pullback from the 16 area. Stay tuned!
Another comment to help a reader understand risk: All the big banks in the US will be able to show how they have balanced their risk with counterparties. They may have huge liabilities with the billions of dollars they have in deposits and much more with leverage they have taken; so they can say if one investment goes south they have this thing or that thing to cash in on to balance it out. But it is worth pointing out a potential problem if it turns out that the this or that thing cannot pay up.
The world is a financial spider web of deals, and one spark (that Minsky moment where many grains of sand start to slide), can bring a whole house of cards down. Indeed much of the crash was caused by the heavy selling of otherwise good stocks in September 2008 as companies sold what they could to raise cash, when they could not sell what they wanted.
For reasons like this that we cannot know we use stops.
Trade with a plan
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