Sometimes I love this business

Those who criticize market timing don’t understand what market timing really is. Market timing, to be clear, is NOT—I repeat NOT about having the clairvoyant ability to predict exact peaks and troughs. BTW- If any reader believes they  possess an unfailing ability to predict market peaks and troughs, please forward your resume to me immediately with proof. I will either hire you and start you at $1MM salary (plus lots of bonus incentive) or– I will have a nice man in a white coat come to visit you and take you away. Likely the latter.

Businessman Consulting Glowing Crystal Ball

Market timing is not about picking peaks and troughs. That’s called crystal ball prognosis, or owning a time machine. I own neither a crystal ball nor a time machine. I do, however, “own” some tools to analyse risk vs. reward potential. I can quite accurately, using historic data, show you when risk is higher or lower than historic norms on a stock or a market. And I do this type of risk analysis pretty accurately most (not all) of the time. Market timing—REAL market timing that is, is about recognizing that markets ALWAYS have risk, and ALWAYS have reward potentials simultaneously. A good market timer will simply decide to overweight or underweight their exposure to a market according to that degree of risk vs. potential return. I’d like to take a look at a few of the tools I use to assess risk and reward. This list is not all inclusive—I will focus on a few of the more interesting ones today. We’re focusing on the broad US market factors that I like to look at.

 

Volatility (VIX)

This is a measurement of option premiums. The more premiums being paid, the more volatility option traders are anticipating. Historically, when the VIX gets near 10—its “too quiet”. If it’s around 35—traders are “too worried”. Right now, they are too worried. That’s good. The chart below shows this tendency since 1996—market don’t like to hang out at the top end of this band for too long…

vix long

Put to call ratio

Investors normally prefer call options (the right to buy a stock at a certain price and date) over put options (the right to sell a stock at a certain price and date). That’s because normally markets are bullish/trending up. When put volume exceeds call volume—as it is now, it is a sign of capitulation. Everyone wants to hedge their stocks or make a bearish bet after the market has already fallen—and it’s too late to do so. We’re at the top of the put/call historic ratio range. This is a contrarian sign of markets getting ready to bottom.

put to call

New high/Lows

Here’s about 20 years of data of NYSE stocks making new highs vs. those making new lows. This is a breadth—i.e. a market participation indicator. You can use it to see if there are not enough participants in the broad markets—that can give a warning sign when markets are too focused on one or two sectors—such as in 1998 (tech stocks), 2007 (energy, real estate). That’s a heads up for bad stuff to come – note the low levels of this indicator near the bottom of my range-lines in both of those periods. But you can also look at this indicator to note if things are getting too oversold. Obviously in a market crash, you will get less new highs vs. new lows on a broad basis. So it’s not a concentration problem—it’s a sign of mass-panic. And mass panic is good for us contrarians. We’re near that point on my noted range lines. The Beatles sang:  “It’s getting better all the time!”. Risk is shrinking.

new high low

And finally…my favorite indicator!

Somebody wrote me an email a month ago asking me to stop using the term “dumb money” when referring to retail investors. Well, I was sorry to tell this person that the terms “smart money” and “dumb money” were not created by yours truly. It’s been a tool used in technical analysis for a long, long time. And I think it’s a great term.

BTW—we’re all dumb money. Unless you are managing a large pension fund, or a sophisticated commercial hedger, or Warren Buffett/George Soros/ Bill Ackman—you are likely in the dumb money category. Take heart, I am too! So let’s just acknowledge our dumbness, and then use that knowledge to fight our natural emotional tendencies to buy high and sell low. Let’s follow the smart money. And right now—the smart money is BUYING!!!!!!! Meanwhile—dumb money (not you and I of course) is SELLING!!! This is the single best thing we can see as a sign of good times to come. The chart below, courtesy of www.sentimentrader.com, shows us the level of smart investor confidence is soaring with a 90% confidence level—something rarely seen except at market bottoms – meanwhile the dumb money confidence level is plummeting—only 29% of your local unsophisticated investors likes equity!

So go ahead, tell that neighbour (preferably one who you don’t care for) that he should keep selling his mutual funds now that markets are low. It’ll finish washing out the market when he’s all out, and then you and I can step in – along with the smart money. We’ll buy the cheap stocks his fund manager had to sell to meet his redemption. Sometimes I love this business!

Smart dumb $

25 Comments

  • Thanks for the heads up and great teachings. Been following the blog for several months now.

    So now the question is do we go straight up from here or re-test? What kind of metrics (or levels) would you suggest to look at to see if this bounce is sustainable? Thanks again.

    Reply
    • This seems to be the question of the day–see my other replies–thanks Deshy

      Reply
  • Hi Keith
    Do you think that there will be a test of the drop we had on Monday? I’m wondering why all the smart money (90%) is buying now when the retest hasn’t occurred?

    Reply
    • Leo–See my comments to Rebecca re a test
      Re Smart money–they and the other indicators I show are LEADING indicators–they show what will happen in a while, and they are quite accurate (these exact indicators showed me to sell aggressively in April!!!). But they are not short termed signals. Smart money–i.e. insiders, commercial hedgers, etc, tends to buy low when they see value in their area of expertise. They don’t try to pick exact bottoms, they just know when its getting cheap enough to begin committing capital.

      Reply
      • Thanks. I admire your full time teaching for the many followers.
        How do you manage the time?

        Reply
        • Funny you should mention that (how I find the time).
          Answer–I work my butt off. I do lots of research on Sunday evenings before coming in to the office Monday, and also do quite a bit of my charting in weekday evenings and in the morning. I also have a fantastic support system from my staff here, and wife at home. This allows me to spend an hour each morning when I arrive designing a blog or preparing an article for publication in one of my newsletter/newspaper obligations. My staff makes sure I am not too interrupted in those first hours of the day. I never trade before 10:00 am anyhow–preferably much later to let the market trend develop in the day so I get lots of my work done in the first 1-2 hours of the day –well before I get to decision making time.

          Reply
  • Came back looking for a response and seems my first comment got deleted.

    Any thoughts on metrics to look at to see if this is a dead cat bounce or (a more rare) “V” shaped recovery?

    Thanks

    Reply
  • Hi Keith,
    If you anticipate a strong bounce like what we had today even it won’t last long, why not deploy small portions of cash to enjoy 5% of gain? Thanks!
    Rebecca

    Reply
    • Rebecca—We used the intra day turn the other day to buy equity for our new clients–who I had been sitting on their cash for about a month (which turned out to be a great decision!). However, my model still shows nearly 50% cash weighting. I may dip into oil if, and only if, it can hold above $38 (so far so good) for a few more days. But I am not anxious to dive in too much–there is the seasonal factors to watch, and often markets retest bottoms. In other words, we may get one more dump before the good times begin. The indicators I showed on todays blog show a big picture scenario where markets look prime to go back to the bull trend after an initial base building phase.

      Reply
  • if the dow theory is flashing a sell signal right now, would you be ready (at some point) to short this market accordingly?

    thanks for the enlarged graphs that you display.

    Reply
    • JP–Actually the indicators I showed on todays blog show the opposite–conditions are improving for a “buy” signal.

      Reply
  • I see sentimentrader ran the stats on crash declines like this and on average it takes the market about a year to recover to new highs from this kind of selloff… any thoughts Keith?

    Reply
  • I guess it depends how short term you trade. On the daily charts has bounced into the 1980 level which is an area of resistance from the start of the year.

    Reply
  • Keith – they say bull markets don’t happen without the participation of Financials. I see no uptrend there (unlike health, tech etc. which may be simply interrupted right now). Would you put much ‘stock’ in this viewpoint?

    Reply
    • Rob–that makes sense–but my main focus is on broad market depth of participation. In other words, if its just the financials that are moving, it would still be bad. But yes, financials are obviously a major component and a barometer of the economy so leadership by the sector can be important.
      Right now, you are correct–they are not leading. My indicators discussed on this blog are leading indicators, so it suggests that despite the very high potential for a retest of the bottoms after a current rally, the end result will be a breakout and move into a bullish trend–even if that uptrend is less steeply pitched than the recent madness. For what its worth, I think the markets will be following the seasonal trends closer than ever this year. That means a breakout in late October or somewhere near that time point.

      Reply
  • Dear Keith:

    I am not sure how your source does their calculations, but I would like to make a few points.

    Technician Stan Weinstein used to have a First Hour/Last Hour indicator in his market letter which shows how the Weinstein calculations were done. The Public (Dumb money) were responsible for the first hour and the pros (Smart Money) the last hour.

    A more accurate calculation is as follows:

    Public: The difference in price between the previous close and the next trading days open.

    Pros: The difference in price between the opening and closing prices of a given trading day.

    Theuptrend.com is a Toronto based trading service which uses the above calculations to chart a Pros and Public chart line for almost all traded instruments (thousands) and has done so for over 10 years.

    You and your followers may benefit from the above.

    Reply
    • Russ –thanks for this, I shall visit the site and enjoy reading all about the research your firm does–and thanks for bringing it to our attention.
      The first hour/last hour studies have been around for many years–I first learned about the study from Gurney Watson, former TA at Merrill Lynch Canada when I worked there in the 1990’s. Stan’s work was influential in my work–especially his work surrounding market phases.
      I did a study on my own back about 10 years ago on the DJIA to see if there was predictive value in the first/last hour theory. I went back for about 20 years–and didn’t find it too useful. But I’d love to learn more about it, as it is an area of interest to me.

      Reply
      • Dear Keith:

        I’m just a user of TheUptrend.com for many years. The site was founded and is operated
        by professional trader Stephen Whiteside.

        Russ

        Reply
    • Hi Keith,

      I was confused about this myself. I follow The Uptrend and The Sentiment Trader as well as your blog here on Value Trend. The Smart/Dumb money confidence chart according to The Sentiment Trader, is essentially reflecting commercial hedgers using indicators like the OEX put/call and open interest ratios, commercial hedger positions in the equity index futures, and the current relationship between stocks and bonds.

      This is not the same as the Pros/Public chart in The Uptrend which as Russ says, is a calculation involving the opening and closing prices. The Smart Money Index chart from The Sentiment Trader, is calculated from the opening and closing prices.

      The confusion for me, was the different usages of the term smart” money.

      Reply
  • Hi Keith:
    I am in the market with a third of my cash since August 25 to play the rally. Are you a bit concerned the VIX is still elevated and in backwardation. Also, your comment break out in October, is it based solely on seasonality. Thanks.

    Reply
    • My October date is based on seasonality–but it would line up with a “typical” market bottom pattern- which will have 2-(sometimes 3) tests –the time it takes for that to play out will likely bring us into October–not a coincidence in my opinion.
      As far as the backwardation of VIX–as I understand it, this is the near termed spot being priced higher than the futures–thus, would that not imply a future optimistic bet? I have not done any studies to see if that is a contrarian sell signal. Sorry–I cant offer insight here.

      Reply
      • Hi Keith:
        Thanks for your usual expert and in-depth response. I find you favorably impact the dumb side of my head. I am using your comment on the October as partial rationale to write calls on some of my long stocks such as FB and close out the calls should the market fall during this October period and pick up some premium. Good day.

        Reply
    • Its an interesting study–I certainly wont argue against another blast down in September. Seasonal’s alone give some leverage towards that end. Also–you probably know that I really don’t endorse the idea of a “V” bottom–so I do take Tom’s work to heart. Thanks.

      Reply

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