Bullish or Bearish? Week of July 25, 2016

As promised, and after a lengthy absence, I am writing a weekly (or monthly) column on how to use market indicators and clues to help determine market direction. Here is this week’s column ( http://goo.gl/CzYnLd ):

One of the most important skills traders learn is how to decipher clues as to the market environment. Even if you are trading individual stocks, it is essential to be aware of the overall market. Such clues can help determine whether you should move to the sidelines in cash, buy on the dip, or use short-selling strategies. 

Here are several market clues I’ve recently observed: 

1. MarketWatch columnist Mark Hulbert recently wrote an insightful column highlighting the Hulbert Nasdaq Newsletter Sentiment Index (HNNSI). This is a contrarian indicator: when the HNNSI plunges, and sentiment is pessimistic, it’s bullish. When the HNNSI soars and sentiment is overly optimistic, it’s bearish. Currently, Hulbert notes, “the HNNSI stands at 77.8%, more than 130 percentage points higher than it was three weeks ago.” Accordingly, Hulbert says, the odds of a coming market pullback or plunge are higher. 

2. In addition to the HNNSI, the Investors Intelligence (II) sentiment survey is currently at 54.4% bullish vs. 24.7% bearish (as of July 19), which confirms Hulbert’s sentiment gauge. Bottom line: The crowd is overly bullish, and that usually does not end well. (In addition, the American Association of Individual Investors (AAII) sentiment survey is also bullish: 35.4% bullish vs 26.7% bearish as of July 20.)

3. Volatility has collapsed to levels not seen since before the previous plunge. The CBOE Volatility Index VIX, +0.70%  is currently around 12.0. Such a low point for the VIX suggests that investors have little fear of a market selloff. When volatility is this low, it is best for traders to stay on the sidelines (especially if you are trading index options). 

4. Longtime market observers say that computer algorithms appear to be artificially boosting stock prices. For months, whenever the market sells off, a massive algorithm consistently buys S&P futures contracts on every dip. Some believe the Fed is behind such a massive buying program, but there is no evidence so far. 

What’s evident is that a entity with unlimited resources is buying on every dip (and also spiking the S&P futures around 2:30 a.m. ET each trading day). The result is that volatility has been crushed, as reflected in the low VIX levels. Even on small pullbacks, volatility is reduced and a buy-the-dips program stops the retreat. 

5. The one-year return for the S&P 500 SPX, -0.30%  is around 1.75%. Although thebulls are giddy , the facts are that the market has gone nowhere in the last year, even though U.S. stocks are at all-time highs. Put another way, the market has tried multiple times to break out of this long sideways trend but has barely made headway. 

6. Well-known market experts including Carl Icahn, George Soros, Stanley Druckenmiller, Jeffrey Gundlach, and Larry Fink are advising investors to either get into cash or go short, and this cautionary advice gets little or no respect. 

7. A three-month chart of the S&P 500 shows that the market has been in a slow-motion melt up since the Brexit lows (a 9% surge). Some individual stocks are at nosebleed prices with long-term RSI levels of 100. Many technical signals appear broken, which is why many traders believe the market is being manipulated. 

8. Finally, although the market is making new highs, volume has been declining, which is a huge red flag. Lance Roberts discusses the dangers of low volume and central bank intervention in his Real Investment Advice blog . His advice: Take profits from the recent advance sooner than later. 

Based on the above clues, it appears that a short-term U.S. market top has formed. Although it is tempting to short the perceived top, it is too dangerous to do so. After all, the market could still go higher from here, creating a more extreme market melt-up. If some investors are afraid of missing out, shorts will continue to get shredded. 

Instead, it’s prudent to wait to see how the market reacts at these overbought levels. If the bulls are right, the market will push higher. But given past market behavior, the danger signs are everywhere.