Technical analysis requires investors to identify a trend, position with that trend, and then exit the trade when the trend shows signs of reversing. A proper analogy is people boarding a boat. When we first get on a boat and walk to one side, the boat remains balanced. As more people join us on our side of the boat, it becomes crowded. Once too many people have arrived on our side, the boat is no longer balanced and tips. Trading is the same way. Eventually so many people rush into the same trade that a market is imbalanced and set to reverse.
While many of the stock-specific technical patterns previously discussed can indicate reversals, we can also use sentiment indicators to gauge the market’s mood. When these indicators push too far in either direction, we must watch for reversals.
There are many different sentiment indicators in the market. In addition to the proprietary methods I have created, I find these five to be the most useful:
1. CBOE Volatility Index (VIX) – VIX is often referred to as the fear index. Based on option prices, VIX increases when investors buy put options to insure their portfolios against losses. A rising VIX indicates an increased need for insurance. By looking for spikes in the index, we can identify moments where fear has overwhelmed the market, giving us the opportunity to buy stocks at reduced levels. Look for a spike where the current price is 10 points above the 10-day moving average (MA). Such a quick move higher indicates mass fear.
2. NYSE High/Low – This is calculated as the number of stocks at 52-week highs minus the number at 52-week lows. When price swings reach extremes, we expect to see spikes in this ratio. As the chart shows, each important interim low during this bear market was accompanied by a spike lower in the ratio (black circles). Investors buying at these points saw quick, material profits.
3. NYSE Bullish Percentage – This measures the percentage of stocks on the New York Stock Exchange (NYSE) that are in bullish technical patterns based on point and figure graphs. In a normal market we would expect this metric to range between 40 and 60%, as some strong stocks are offset by weaker ones. When the number travels too far to either extreme, it indicates markets are either overbought (greater than 80%) or oversold (less than 20%).
4. NYSE 50-day moving average – This is a measure of the percentage of NYSE stocks trading above their 50-day moving average (MA). Stocks above the 50-day MA are indicative of a rising market. As with the NYSE bullish percentage, look for extreme readings as an indication that the market is ether overbought or oversold.
5. NYSE 200-day moving average – This is a measure of the percentage of NYSE stocks trading above their 200-day moving average (MA). The longer the MA the more weight it should be given. When we see the percentage of stocks above their 200-day MA rising or falling, it indicates the broad market is also heading in that direction.
Sentiment indicators provide insight into the underlying strength of market movements. Look for extreme readings as an indication that prices are set to reverse.
Sean Hannon, CFA, CFP is a professional fund manager.