Never-Before Seen Indicator Suggests More Downside Ahead

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The past month has been a rollercoaster for the markets.

Within one week the Dow Jones Industrial Average completely erased its 2014 gains, only to rebound over the following weeks, leaving it up a measly 1.3%.

One of my goals as Chief Investment Strategist of Alpha Trader is to alleviate the emotion that naturally comes with watching your investment portfolio wildly fluctuate up and down. I do this with a rules-based, systematic approach to the market.

Throughout the latest bout of market weakness, our Alpha Trader system responded precisely as it was designed to. Since the market began to show weakness in July, we've closed out a total of 59 positions while only adding 28 new stocks to our portfolios.

During this period, we were able to sell positions well before they moved further to the downside in sympathy with the wider markets. Moreover, our trading rules allowed us to capture some exceptionally large gains since July:

Company Holding Period(Days) Return
Amkor Technology (Nasdaq: AMKR ) 168 57.7%
Hi-Crush Partners LP (NYSE: HCLP ) 365 66.1%
ANI Pharmaceuticals (Nasdaq: ANIP ) 252 114.1%
Bitauto Holdings (NYSE: BITA ) 365 242.2%

Closing out winning positions in the face of a crumbling market is exactly what the Alpha Trader system is designed to do.

But now the logical question here is -- what's next for the market?

One clue to where the markets might be heading can be found in the psychology and emotions inherent whenever investors experience big swings in the market.

Let's take a look at the following graphic, courtesy of, to see how the emotional cycle of market swings tends to play out.

As you can see, when investors get excited about rising investments, their excitement quickly becomes euphoria. It is during this euphoria stage that investors tend to move headlong into the riskiest asset class (stocks) with little fear of consequence.

When the market begins to come down, that's when anxiety starts, which leads to fear taking control and, eventually, a state of psychological depression regarding the market. As a result, a simple price correction in stocks can lead to a full blown sell-off.

This psychological model certainly makes sense, but is it quantifiable in the real world?

After careful analysis and some old-fashioned trial and error, I've come up with an indicator that can track where we are in the psychological market cycle. I would never trade based on this indicator alone, but it does a great job of showing us if we're closer to depression or euphoria levels.

I hadn't published this indicator to a wide audience before, partly because it's a little more difficult to understand than most indicators. However, given the insight it provides about where we are in the sentiment cycle, I think it is critical you see it now.

This sentiment indicator, which is plotted above the S&P 500 in the chart above, is based on two key data points.

The first is the percentage of stocks in the S&P 500 that trade above their 150-day moving averages. The second data point is the CBOE Volatility Index, or VIX. The VIX is commonly known as the "fear gauge," and it gives market technicians a way to quantify the amount of angst in the market -- the higher the VIX, the greater the expected volatility.

When these two data points are plotted together on a chart, we get a feel for where the market's "depression" and "euphoria" levels reside.

For example, during the market sell-off in late 2002, we saw a very low reading in our sentiment indicator. We saw even lower levels in late 2008 and early 2009, just as the market bottomed during the Great Recession.

In early 2007, when the market was at multi-year highs, we saw our sentiment indicator reflecting the "euphoria" state, in this case above 8.

Recently, we witnessed what looks like another "euphoria" moment, as the sentiment indicator vaulted to just below 7. This is the second highest reading in the past decade, second only to 2007's pre-crash euphoria.

This doesn't necessarily mean the market is about to plunge to "depression" levels, but it does appear that we're closer to the end of this bull market than we are to its beginning.

One thing is clear; the market is at a crossroad and investor emotion is starting to take control. And when that happens, the Alpha Trader system signals when it's time to get out. We don't want to be holding stocks that are being controlled by irrational investor sentiment.

The best course of action now is to be patient and wait for the market to demonstrate that momentum is once again trending in our favor.

In the meantime, Alpha Trader will continue to do what it was designed to do -- hold on to stocks likely to continue outperforming in the coming weeks and months, and exit stocks vulnerable to the change in momentum occurring in the market.

I talk much more in depth about my special indicator in the most recent issue of Alpha Trader , but one thing is clear -- to outperform in such a volatile market, a rules-based system is paramount to success. Using the Alpha Trader system we've been able to stay ahead of these big moves. To find out how we're able to bag 114% and even 242% returns in less than a year with the Alpha Trader system, read this report .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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