One of the most common misconceptions among retail investors is the belief that active traders must always be actively trading. This simply isn’t true.
In fact, one of the greatest benefits of being an active trader instead of a passive investor is you can choose when you want to trade and when you don’t.
When times are good, active traders can take strategic advantage of the bullish moves on Wall Street. When times get rough, active traders can strategically scale back their trades and wait for the storm to pass.
This has been our approach in the Strategic Trader portfolio while the financial markets have been in upheaval the past few weeks.
We haven’t completely stopped trading during these turbulent times. On the contrary, we have identified a few excellent opportunities to profit from the market’s current situation.
We have, however, reduced our trading velocity as we’ve been waiting for the stock market to find some stability. After all, there’s no need to try and force a trade just so you can say you’re making trades.
We don’t expect this situation to last forever though.
Based on a few of the contrarian indicators we have been watching, we have reason to believe we are getting closer to finding some stability, at least in the near term.
We’ve been watching the following three key contrarian indicators to see what they can tell us about the possibility of the S&P 500 finding support:
Today, we’re going to take a closer look at all three of these indicators.
Most traders tend to focus solely on the CBOE Volatility Index (VIX) when they think about measuring trader sentiment.
The VIX is a measurement of the anticipated volatility being priced into S&P 500 options for the next 30 days, and sometimes focusing only on the next 30 days isn’t a long enough view.
Sometimes it is helpful to expand your horizons out to the next 3 months, or 90 days. When traders need a longer-term outlook, they can look at the CBOE 3-Month Volatility Index (VIX3M), which is a measurement of the anticipated volatility being priced into S&P 500 options for next 90 days.
By comparing the value of the VIX to the value of the VIX3M, you can identify periods when trader sentiment has turned extremely bearish and when it has normalized.
Because these volatility indices measure the magnitude of the price movement traders believe the S&P 500 may make during the measured time frame, the value of the VIX3M is usually higher than the value of the VIX.
After all, if you give the market three months to make a move — like the VIX3M measures — instead of just one month — like the VIX measures — it has a greater chance of making a larger move.
Interestingly, there are times when traders will price in a greater chance of a larger move in the short term because they are nervous the market is about to drop. This pushes the value of the VIX up higher than the value of the VIX3M.
The easiest way to compare the value of the VIX to the value of the VIX3M is to create a relative-strength chart of the indices where you divide the value of the VIX by the value of the VIX3M.
Typically, the VIX/VIX3M relative-strength chart will have a value less than 1 because the value of the VIX is usually less than the value of the VIX3M.
During periods of high market stress, the VIX/VIX3M relative-strength chart will often have a value greater than 1 because traders are pushing the value of the VIX higher than the value of the VIX3M.
So where is the VIX/VIX3M now?
According to the chart below, the VIX/VIX3M is currently sitting at 1.3.
This is well above the threshold that most traders are watching for. In fact, this is the highest the indicator has been since early 2018, when the market started pulling back as longer-term yields were climbing higher — sparking concerns that the economy was slowing down.
The readings on the VIX/VIX3M are even higher than they were during the bear-market pullback of late 2018.
Typically, these extreme levels of bearishness don’t last long. Once the market moves to these extremes, bearish momentum will usually subside as sentiment reverts to the mean.
We wouldn’t be surprised to see the same thing happen here.
The next indicator we have been watching is the number of S&P 500 components that are trading above their 200-day simple moving average (SMA).
When a stock is trading above its 200-day SMA, it shows the stock is relatively strong. When a stock is trading below its 200-day SMA, it shows the stock is relatively weak.
Looking at the daily chart of the S&P 500 Stocks Above 200-Day Average (S5TH) below, you can see that only 14.5% are currently trading above their 200-day SMA.
While it may be a bearish sign that so few stocks are trading above their 200-day SMA, this chart can also serve as a contrarian indicator.
When the number dips too low — below 20% — it suggests the pendulum has swung too far from bullish to bearish and the market may be set for a rebound.
We’ve seen that happen a few times during the past few years, and the pendulum may be ready to start swinging back toward the bullish side — above 50% — of the chart soon.
The last time this chart dipped below 20% was during the bear-market pullback of late 2018, and the S&P 500 enjoyed a strong rally as the pendulum swung back after that pullback.
When option traders are bullish on the stock market, they tend to buy call options — which increase in value when the price of the underlying stock moves higher. Conversely, when option traders are bearish on the stock market, they tend to buy put options — which increase in value when the price of the underlying stock moves lower.
The CBOE Put/Call ratio is an indicator that tells you the relationship between the number of puts that traders have purchased on stocks compared to the number of calls traders have purchased. It divides the number of puts purchased by the number of calls purchased.
If traders have purchased more put options than call options, the ratio will be greater than 1. If traders have purchased more call options than put options, the ratio will be less than 1.
Looking at the chart of the CBOE Put/Call ratio below, you can see that traders have been purchasing many more puts than calls this week.
The last time the CBOE Put/Call ratio was this high was during the bear-market pullback of late 2018. It briefly rose to 1.825 before retreating to consolidate below 1.
On Monday, the CBOE Put/Call ratio rose even higher, tapping 1.836 before pulling back.
These extremely bearish surges often indicate the last panicked bearish push before the market regroups and finds support. We’re waiting to see if that happens again this time.
You can see on the daily chart below that 2,725 had served as support in the past, but that level couldn’t hold during today’s selloff.
The next level we were watching was 2,600. This level was based on the longer-term up-trending support level that has been interacting with the index for the past few years, but just like 2,725, it didn’t hold.
You can see this level on the weekly chart of the S&P 500 below.
Despite the speed of the decline, the market rarely moves in one direction like this for several days in a row. Usually, panic selling is interrupted by panic buying — and short-covering — like we saw on Tuesday.
We think investors looking to buy off the lows could send the index up at some point over the next 1 to 3 days, giving the market a chance to establish a bottom. At the very least, it will give traders a chance to catch their breaths.
We will remain patient until we see what the fundamentals look like at that point.
The dramatic volatility we’ve been living through on Wall Street for the past few weeks hasn’t showed any signs of letting up. However, there are signs we could find support soon.
We plan to be strategically cautious until that support is confirmed.
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