Stock market dips: Time to buy or budding correction?

Stock bull markets don’t rally higher in a nice linear fashion. Their advance is much more chaotic, flowing and ebbing. Two steps forward are inevitably followed by one step back. Today the US stock markets, despite their recent selloff in early March, still look to be in this correction mode. These ebbings present stock traders with awesome buying opportunities, the best ever seen within ongoing bulls.

Corrections exist for one reason alone, to rebalance sentiment. Sentiment is simply how traders as a herd happen to feel about the stock markets at any given time. Sentiment swings like a giant pendulum, perpetually oscillating back and forth between its polar extremes of greed and fear. These powerful emotions are finite and self-limiting. The more extreme they grow, the more likely the pendulum is due to swing back in the opposite direction to restore balance.

The physical mechanics of pendulums aptly illustrate the psychological cycles in the stock markets. As a pendulum nears the top of its arc, its momentum gradually slows and then stops. The swing has a limit. And once it starts swinging back in the opposite direction, it accelerates. Though this kinetic energy peaks halfway through its arc, it isn’t fully bled off until the pendulum reaches the opposite extreme.

Stock-market sentiment works the same way. After an episode of extreme greed or fear, sentiment doesn’t just start swinging back and then magically stop mid-swing. Instead it gradually builds momentum that isn’t exhausted until the opposite extreme is finally reached. After episodes of extreme greed, sentiment doesn’t stabilize until we see extreme fear. And this is the main reason why an SPX correction still looms.

Back in late January when I wrote my original essay in this series, key sentiment indicators were warning of extreme greed and complacency in the stock markets. Soon after such levels were hit in the past, the SPX corrected. Incredibly though, despite being super-overbought, the stock markets were able to defy the odds and power higher for another month into mid-February. Finally then the overdue selling arrived.

But by mid-March after that monster earthquake and tsunami rocked Japan, the SPX had only fallen 6.4% since its latest interim high. This is a minor selloff, well below the 10% threshold that defines a full-blown correction. The problem with little selloffs is they don’t generate enough fear to offset the excessive greed and complacency seen at recent highs. Thus the sentiment pendulum appears to stop mid-swing.

But don’t be fooled, the stock markets abhor sentiment extremes. If an overdue selloff appears to end before sentiment is rebalanced, odds are very high that the selling isn’t over yet. Any rally that interrupts this healthy and necessary process is probably a crafty head-fake to trap the remaining bulls. The sentiment indicators are clear in suggesting that the pendulum swing from greed to fear has only started.

Back in late January I highlighted several of the many sentiment indicators showing the high risks for a correction in the stock markets. Today these same indicators reveal that sentiment was not rebalanced by the relatively-minor 6.4% pullback in early March. These, coupled with the fact the SPX is still very overbought (it rallied too far too fast relative to its own 200-day moving average), argue for an imminent correction.

The first is the premier sentiment gauge, the VXO. This is the original old-school VIX before that index was heavily modified and watered down in September 2003. It measures the implied volatility of at-the-money options expiring 30 calendar days out in the elite S&P 100 index. These companies are the top 20% of the S&P 500, the biggest and most-liquid stocks. Their heavy volumes allow big sellers to exit quickly with minimal adverse price impact, so they are sold first and fastest in any meaningful SPX selloff.

Low VXO levels reflect extreme greed and complacency, while high ones signal extreme fear. I used this excellent indicator to call the major multi-year bottom in real-time in March 2009 that marked the beginning of today’s cyclical stock bull. The VXO is an invaluable tool, its responsiveness in reflecting the psychological state of the great majority of stock traders is unparalleled. And it continues to reveal extreme greed and complacency today.

The VXO is rendered in red here, slaved to the left axis. The S&P 500 (blue) and its key moving averages are tied to the right one. Every pullback and correction of this entire cyclical stock bull is highlighted. There have been seven pullbacks (less than 10%) and one correction (greater than 10%) so far. Of particular interest right now is what happened to the stock markets soon after the VXO entered its low danger zone.

Whenever the VXO drifts down to that red band in this chart encompassing a couple points on either side of 15, a major interim high is soon hit and a selloff ensues. Back in January 2010 after the VXO slumped to 16.5, the SPX fell 8.1% in what is still its biggest pullback of this entire bull market. This selling drove a sharp surge in fear, which the VXO “measures” by quantifying trading activity in stock-index options.

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