By: Chris Rowe — August 10, 2016
Well that was certainly a crock.
Since May 1, the S&P 500 is up 5.65%.
Compare that to its 30-year average annual return of 7.5% and you're talking about one hell of a summer. Well, a "hell" of a summer for bearish investors and a heck of a summer for bullish investors.
For today's article, I'm writing back to the traders who thanked me for the June 14th article, when I showed you why I thought the stock market would soon decline 5% - 10%. The Brexit thing crushed markets about one week later.
You see, today I noticed another key indicator suggesting more headwinds for stocks.
"Did the same uncle suggest selling stocks before the typically volatile month of October?"
But conventional wisdom can be very useful to savvy traders.
You see, the indicator I'm talking about essentially compiles data from the collective drunken uncles... and then suggests that you bet on the stock market moving in the opposite direction.
Well, I may have been oversimplifying for the entertainment value.
In all seriousness, Investors Intelligence gathers weekly investment outlooks from over 100 independent investment advisors and money managers, determining what percentage have a bullish outlook, a bearish outlook or are waiting for a market correction to jump in.
The indicator has incredible accuracy, as long as you know how to use it correctly.
I'll cut to the chase.
This contrary indicator is showing too many advisors feeling bullish and too few advisors feeling bearish about the next few months. When the reading is "overly bullish" it means we are looking at a "crowded trade."
In other words, the investors polled aren't your uncle on his e-Trade account. They manage hundreds of millions or billions of dollars, so their mood does actually affect stock prices.
When too many of them are bullish, it means they're probably fully invested (with no more money to support a further advance in stock prices). It also means the stock market is vulnerable to a sharp decline, because there's that much more stock for sale when these advisors decide to raise their cash position to 10% or 20%.
At market bottoms, the indicator is extremely useful for guiding us into the stock market, even though everyone you know is telling you to get the heck out. Those are the overly bearish readings, shown by the green arrows, below.
But when markets are near tops, it's a different story.
The indicator's overly bullish signals tend to either mean that we are at or near a major top, OR that the market is likely to trade sideways with a short-term dip. Tops also tend to take longer to pan out.
So this isn't a precise "sell recommendation". Instead, I'm saying stocks should be topping out somewhere in here. It could take a month or so but because we face the headwinds I've mentioned, it makes sense to think ahead about how to handle this next 30 days or so.
The best way to gauge whether we are likely near a major (long-term) top or just near a likely plateau is to consider what other technical indicators are saying about the stock market.
Here's the quick-n-dirty...
Relative to the 6 other asset classes, U.S. stocks are pretty much neck and neck with commodities as being the strongest asset class. We have seen many indications of a continued long-term bull market.
Since the February stock market low, stocks have been gradually and consistently gaining relative strength.
Ask your uncle about the old adage "the bigger the base, the bigger the breakout." Stocks have just completed the biggest base I've ever seen. In fact, they just broke out of what MarketWatch is calling the longest base/correction in stock market history.
We expect more upside, but after some consolidation.
Back to The Investors Intelligence Advisors Sentiment Index
When the percentage of bullish advisors reaches 55%, it is a sign that we are at or near a top. Currently, the weekly reading shows 54.3% of advisors being bullish.
Another way of looking at this is the difference between the percentage of bulls and the percentage of bearish advisors. When there's a big difference between the two, it means there is too much optimism.
Currently only 20.90% of advisors are bearish.
With 54.3% of advisors currently bullish, that means there's a 33.4% difference between the two. Anything greater than a 30% difference is considered an overbought warning signal. When the difference is close to 40 it's a huge warning to bulls.
So What The Heck Should We Do?
The proper course of action to take at this point is to be a bit more cautious.
Paying extra close attention to which positions are outperforming, and which positions are underperforming.
Positions that have been underperforming are most likely to have the most weakness should we experience a stock market dip. It makes sense to exit those positions now.
(By the way, be sure to watch out for an article from Costas tomorrow. He showed me an early draft that included his analysis on one sector that's been outperforming pretty much everything else out there. If you've been following his articles, you know that he's been on an incredible run in terms of profitable recommendations, so don't miss this one.)
Another course of action is to take the suggestion we made last month, which is to hedge stocks with gold.
Gold has been the strongest asset class lately anyway. But if something causes sentiment to change from "risk-on" to "risk-off", investors are likely to buy gold as a flight to quality.
Finally, we think this is a perfect market for selling options to collect premium. If you're not familiar with this strategy, it's best to ask your broker for some help.
Selling covered calls on the positions you are still holding is a great way to collect some extra income. Since stocks are still pretty strong, it makes sense to sell call options that are slightly out-of-the-money (a call with a strike price that's slightly higher than the stock's or ETF's current price). Typically each option contract represents 100 shares of stock so we would be selling one call option for every 100 shares of stock we own. We sell call options that expire 30 - 45 days out.
Selling naked puts (which is the synthetic version of selling covered calls) is a clever way to back yourself into a new stock or ETF position. We would want to sell the slightly out of the money put option (sell the put with a strike price that's slightly below the stock's or ETF's current price). Again, we sell call options that expire 30 - 45 days out.
If, on expiration day, your stock or ETF is trading at or below the strike price, you'll own the stock or ETF the following Monday. You'll own it at a lower price than it was trading today, and you will have also collected a nice premium for selling the put in the first place.
I hope this article helps.
Founder, True Market Insider