The current US market conditions are showing a very overbought scenario, though last night’s big rally would seem to contradict this idea. While overbought can be monitored by looking at charting indicators such as RSI, Stochastic, or Money Flow Index, there are other measures of overbought to consider.
In the US a company called Investors Intelligence collects survey data on bullish and bearish views on the market. In the chart below you can see that this survey has reached a highly bullish outlook. Highs of this magnitude are often followed by declines in the S&P 500 plotted below. These drops do not occur immediately, but 1 month out the market underperforms and returns become negative 3 months out.
Sometimes it is not wise to listen to what people are saying, but better to watch what they are doing with their money. There are futures contracts and options available on all of the major indices. Monitoring the positioning of traders in these instruments can also give an insight into market sentiment. Currently the long positioning in the Nasdaq futures are at their highest level ever.
In the options market there are two different ways to measure sentiment. One measure, the Put/Call ratio, shows how many puts (bets the market will go down) are being bought relative to how many calls (bets the market will go up) are being bought. Right now levels that have been reached coincide with declines in the S&P 500.
The second method is to consider the premium that is being paid to buy put options as protection. The higher the premium is the more fear that exists in the market. When options are cheaper then investors are relaxed and do not believe the market will decline. Unfortunately, as history shows, periods of cheap options, shown by a low reading on the Volatility Index (VIX) are often followed by declines in the S&P 500.
None of these indicators on their own suggest a market decline, but a combination of indicators like the current setup certainly shows the risks lie in a move to the downside. The timing of a drop however is much harder to predict as overbought conditions can last for a very long time.
By Jeff Cartridge