Credit: Shutterstock photoThe speed of the market's ascent to new highs is similar to Chinese torture - slow and relentless.
With the exception of the January hiccup, the major indexes a la Dow Jones have been inching up a fraction of a percent every day.
Even though volume has been anemic, we haven't seen a down day of more than 1% since early February. This kind of performance is not just unusual, it's eerie. What does it mean?
In general, long and drawn out trends are unhealthy as they cause extreme investor sentiment. Extreme investor sentiment on the other hand has been a historically accurate measure of a trend reversal or significant correction.
Just as a mortal human can only exhale for so long without inhaling, the market can only go up so long without correcting. The longer one goes without taking a breath, the deeper the next breath with be.
A different kind of rally
Most notable about the recent rally leg from the February low is that it has failed to rouse up the kind of optimism seen around the January highs. In January, investors were as enthusiastic about stocks as they were in 2000 and 2007. We know what happened then.
In January, investment advisors and newsletter writers recorded a multi-year record bullish plurality of 53.4%. Retail investors reached a bullish high of 49.18%. As of last week, advisors stood at 48.9%, retail investors at 42.86%. We will talk about the significance of that in a moment.
While investors are bullish with some reservations, option traders have thrown all caution to the wind. At one point last week, option traders bought nearly three times as many call options as put options.
Not only does this translate in an ber-bullish sentiment (which is ber-bearish) it also reveals what kind of decline is on the horizon once the market does change trend.
What options traders tell us
The lack of interest for put options - which provide protection against falling prices - is no doubt caused by the market's winning streak. The lack of volatility has lulled investors into a false sense of security.
It's no secret that the 'Chinese torture market' can continue longer than expected. It tends to give way to swift and powerful corrections or downtrends that erase weeks of profits within a matter of days or hours. How so?
Let's say you own an index ETF like the Dow Jones Diamonds (NYSEArca: DIA), S&P SPDRs (NYSEArca: SPY), or Nasdaq QQQ's (Nasdaq: QQQQ) without put protection. The only way to protect against falling prices is to sell your positions, which will contribute to the negative feedback loop and depress prices further.
If on the other hand your long positions are protected by puts, you are not compelled to sell your long positions as any loss from lower prices is balanced by gains from protective puts.
Historically, a low interest in puts and the lack of put-protected positions means that lower prices are likely to trigger an avalanche of selling. Like one domino triggering the fall of an entire line of dominos. The question is, when will the first domino fall?
The lack of fear is evidenced by the Volatility Index (Chicago Options: ^VIX). Last week the VIX dropped to 16.06. The lowest reading since October 9, 2007, when it closed at 16.12. This very day marked the end of the bull market and the onset of an 18-month waterfall decline.
Even though this rally is more proficient in stringing investors along, heeding sentiment-based warning signs has been a good idea in the past.
In 2008, the ETF Profit Strategy Newsletter used a combination of technical and sentiment indicators to forecast a market top followed by a bottom below Dow 7,500 for 2008 (Dow dropped as low as 7,392 on 11-21-2008) and a market bottom below 6,700 for 2009 (Dow slipped to 6,440 on 3-9-2009).
More room to the upside
A detailed analysis of major double market tops (available in the April 2010 issue of the ETF Profit Strategy Newsletter) shows that investor sentiment does not necessarily have to reach new extremes at the second top, but it would make for a cleaner cut and provide a more logical and convincing kick-off for the bearish ride ahead.
Minor corrections within rising prices give the market an heir of credibility and provide fertile soil for investor extremes. Chances are we will see one more correction before the market stages another rally leg.
This outlook harmonizes with various technical indicators such as pivot points and relative strength measures. In fact, according to percentR, a relative strength measure, the S&P 500 has been in overbought territory longer now than it was in 2000 and 2007.
Even though investing remains a game of probability, combining various sentiment readings with fundamental and technical analysis can tilt the odds in your favor.
The ETF Profit Strategy Newsletter provides a detailed short, mid and long-term forecast based on a composite of indicators. These include resistance levels that might mark the top of this rally and the valuations that should mark the ultimate market bottom.
Over the shorter term, leveraged ETFs that will benefit from a continued uptrend include the Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS), Ultra Real Estate ProShares (NYSEArca: URE) and Financial Select Sector SPDRs (NYSEArca: XLF).
Over the longer term, leveraged short ETFs that will benefit from a correction include the Direxion Daily Financial Bear 3x Shares (NYSEArca: FAZ), Direxion Daily Small Cap Bear 3x Shares (NYSEArca: TZA) and UltraShort S&P 500 ProShares (NYSEArca: SDS).
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
