Investing 101 Lesson #3: Market Indicators

Contrarian Indicators are very important when it comes to timing moves in the market. Although it's virtually impossible to time exactly when the markets are going to change direction, by looking at a few indicators it may give you some warning signs that some type of market reversal is near. For 401k investment ideas there are several indicators you can look at however I tend to focus on the Put to Call Ratio, the Bullish-Bearish Sentiment and the Volatility Index (VIX).

Put to Call Ratio

The Put to Call ratio measures the amount of volume in Puts versus Calls. When Put volume becomes excessive in relation to Call volume, it's an indication of excessive bearishness in the market (a bullish sign). Conversely if Call volume becomes excessive to Put volume, it's a sign of excessive bullishness in the market (a bearish sign). A chart of the Put to Call Ratio versus the S&P 500 is shown below.

Notice when the Put to Call Ratio has risen significantly above "1.0" this has generally led to a market bottom followed by a significant upside reversal.  Some examples include the Fall of 2001 (point A), Spring of 2001 (point B), Fall of 1999 (point C) and back in the Fall of 1998 (point D).   However more recently the Put to Call Ratio hasn't worked as well as their have been some false signals in which the Put to Call Ratio rose well above "1.0" but wasn't accompanied by a strong upside reversal (points E, F and G).  

In addition to signaling a potential short term bottom in the markets the Put to Call Ratio may also signal an impending market top as well. The most recent one occurred in early July (Point A) when the Put to Call Ratio got close to 0.4 and was followed by a market correction a few days later. Other corrections occurred in mid-July of 1998, late September of 1998 and early December of 1998 as the Put to Call Ratio quickly reversed to the downside.

Thus using this indicator as part of your investing for beginners strategy can help determine when the markets may be in for a reversal and help with your trading decisions as even the strongest performing stocks may get hit pretty hard if a market correction takes place. The next indicator we will look at is the Bullish-Bearish Sentiment.

Bullish-Bearish Sentiment

Another Contrarian indicator I like to look at is the Bullish-Bearish Sentiment.  When Bulls get to optimistic and Bears get to pessimistic a wide divergence develops between the two which could signal a nearing top followed by a sell off.  Meanwhile when the Bears get overly pessimistic and the Bulls become less optimistic this allows for the two to converge signaling a potential bottom may be nearing followed by a significant rally to the upside.  The chart below shows the Bullish-Bearish Sentiment versus the S&P 500 Index.

As you can see over the past several years when the % of Bullish Investment Advisors (red line) has been equal to or less than the % of Bearish Investment Advisors (blue line) generally the S&P 500 has made a bottom and reversed strongly to the upside (points A, B, C, D, E, F and G).

Meanwhile when the % of Bullish Investment Advisors has been considerably greater than the % of Bearish Investment Advisors then this has generally led to a nearing top followed by a sell off (points H, I, J, K, L, M, N and O).

The next indicator we will look at is the Volatility Index (VIX).

VOLATILITY INDEX (VIX)

The last index we will look at is the Volatility Index (VIX). The VIX measures fear and optimism as measured by OEX options activity. When large numbers of traders become fearful, the VIX reading rises, and when complacency develops, the VIX reading falls. Since the majority of put/call buyers are usually wrong it's usually a good contrarian indicator. When the VIX exhibits high readings it means the market is becoming oversold (excess of bearishness) and when there are low VIX readings the market is becoming overbought (excess of bullishness). So when the VIX is at extremes it usually gives a good signal of an impending short term bottom or top depending on the current market environment.

In the chart below notice the strong upward spikes in the VIX and how they corresponded to a bottom followed by a significant reversal to the upside in the S&P 500.  Some of the more notable upside reversals occurred in the Fall of 2002 (point A), Summer of 2002 (point B), Fall of 2001 (point C), Spring of 2001 (point D), Fall of 1999 (point E) and back in the Fall of 1998 (point F).   As you can see when the VIX has risen above a reading of "50" this has provided a very strong signal of a nearing bottom over the past several years. 

Meanwhile when the VIX is exhibiting a very low value generally in the lower 20's or below this can signal a nearing top followed by a significant sell off.  Some examples include the Spring of 2002 (point G), Summer of 2001 (point H), Summer of 2000 (point I), Summer of 1999 (point J) and Summer of 1998 (point K). 

Although all three of the indicators (Put to Call Ratio, Bullish-Bearish Sediment and Volatility Index) aren't always perfect they do provide some valuable insight to when a change in the markets is forthcoming and if used properly may help investors with their investment decisions.

Amateur-Investors.com