Two indicators currently stretched and signalling caution for longs include VIX (the Volatility Index) and the Put/Call ratio. The latter, in particular, is helpful in identifying price extremes. For example, when investors and traders are excessively bullish, they will buy more calls vs. puts, therefore deflating the put/call ratio. The theory is that when "everyone" is buying and bullish, there are fewer investors left to keep the rising momentum going. Friday's Put/Call ratio of .58 was last seen on April 15, 2010, one day prior to a 2% pullback in SPX and the start of a11% retreat in the index through May. Timing, however, is tricky with this indicator, and the start of options expiration week this Monday could have skewed Friday's reading a bit. But this is an indicator nonetheless to keep an eye on. See the chart below:
Our next indicator of note is VIX, which represents volatility in equities and trends lower as equity investors become complacent with a climbing uptrend and join the crowd. Our VIX indicator once again flashed a complacency warning sign; with the index falling significantly below its 50-day moving average (it closed Friday at 15.5). The last time such a gap was seen, the SPX embarked on a trading range with no significant pullback to speak of. See the chart below:
VIX can remain "complacent" for a long time. VIX was at this current level in Q4 04 and continued to trend lower through Q1 07 (touching single digits at times) as the SPX marched upward into 2008. During this time frame, however, VIX would go through fits and starts just as equities did, as consolidations and single-digit corrections dotted the landscape. It is interesting to note that at today;s VIX closing level, the indicator almost matches its low formed in April 2010 prior to the aforementioned correction.
Outside of these two indicators, the patient is healthy. At the end of the day, PRICE is the key indicator and that remains positive and yet extended (we track the delta between price and a few of its moving averages, a gap which has underscored the market's extension). Market breadth remains strong. As for resistance, note that the Nasdaq Composite is about 20 points away from meeting up with its 2007 high. Breaking through this resistance level will lend credibility to the prospect of a longer-term bull market. US equities have begun to outpace Pacific-rim markets, and bonds continue to feel the effect of allocations shifting toward stocks. Some emerging markets (i.e. India) are beginning to feel the heat of food price inflation, as several central banks have been raising interest rates, in part to cool QE2-induced cashflow from sparking bubbles in those emerging markets. We may be seeing the start of such a trend. We look at the Pacitic Rim markets (ex-Japan) and have noted their recent underperformance vs. SPX. See the chart below:
As for sectors, Financials and Technology, two sectors we would like to see as leaders in the market, have resumed their relative strength uptrends. Small Caps continue to outshine large caps, and growth continues to beat value.
One of the most disconcerting decisions to make at this juncture is whether to continue to join the crowd and buy stocks. The big doubt in the back of one's mind is whether one is buying at a top. When uptrends gain significant momentum (think back at the 2003-2007 time frame), those who stayed the course, averaging into the market with partial buys along the way, and boosting long positions more aggressively in market pullbacks, were rewarded.
One needs to be mindful of the risks inherent in a strategy this time. Macro-economic conditions underscore the risk: The US is recovering at a slower pace today than it did following the 2001 recession largely due to the absence of growth from housing and stubbornly-high unemployment. The risk of national and local debt levels continue to hang over us as a dark cloud. And inflation seems to want to break out of its cage after being tame for so long (some food price indicators are harkening back to the leap in rice inflation in 2008). Oil price is another concern; will the price of gasoline pushing toward $4 per gallon trip this nascent recovery? In late 2007, as West Texas Intermediate Crude surpassed $90 per barrel (where it sits today), the SPX started to stumble (most likely as mortgage fears surfaced, but perhaps in part spurred by the fear of $4.00 per gallon gasoline). See the chart below:
As we keep abreast of the stage of the recovery and the economic cycle, we can't ignore those sectors that have underperformed and perhaps will "have their day." Consumer Staples, Healthcare, Financials and Utilities have underperformed as Materials, Energy, Technology and Consumer Discretionaries have led. Will potential sector rotation (laggards turning into leaders) provide some guidance as a way to participate in the uptrend? Reviewing our relative strength indicators, Technology and Financials (noting their recent strength), tempered with some weightings in Consumer Staples and Healthcare (shunning Utilities due to interest rate risk) might be a prudent way to approach this market.
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