New indicator suggests caution

The CBOE has created a couple of indicators that help verify market timing signals that are generated by the VIX indicator. One of these indicators that seems to be pretty helpful in finessing a market entry or exit point is the “SKEW” indicator. Here is a whitepaper on the index:

http://www.cboe.com/micro/skew/documents/SKEWwhitepaperjan2011.pdf

I would suggest you read the white paper if you want a complete understanding of this indicator, but the basic interpretation is that it measures the probability of a decline for the S&P500 based on option prices. If the index goes over 125, the probability of decline increases, especially if the VIX level has been low and begins moving up.

The indicator may be one to put on your watch list (you can follow it on the CBOE website). Various peaks in 2004, 2005, 2007, 2010, 2011, and 2012 were all marked by a rise off of low VIX levels and high SKEW levels (125+). Currently, the SKEW index sits at about 130. Meanwhile, the VIX recently got as low as 12.5 (only in 2007 did it get to below that level, when it touched just below 10). The VIX may be starting to move up, (its now over 13), but I’d give it a bit of time to confirm the potential of a meaningful move. Also, the CS “Fear Barometer” (a measurement of call vs. put option premium) is at high levels, according to work by www.sentimentrader.com. The significance of high SKEW and Fear Barometer readings in conjunction with low but rising VIX readings is not only that of implied volatility. It is also somewhat of a “smart money / dumb money” indicator- given that retail investors tend to watch the VIX, and institutional investors (smart money) watch the other two. As Jason Goepfert, proprietor of the sentimentrader site notes, “as institutional volatility indicators (like SKEW and CS Fear Barometer) are hitting high levels, while retail volatility indicators like the VIX are low, the market tends to suffer”.

I remain near termed bullish for perhaps another month or so. I will not fight the trend and the seasonal strength, but I am wary of the continuing signs of a market top approaching. Thus, I remain largely long the markets (I hold over 10% recently raised cash in my equity model), but I do have a finger on the sell button ready to pull as, if and when the time is right. Perhaps a meaningful movement on the VIX will be the incentive to pull that trigger.