Stock market dips: Time to buy or budding correction?

While the VXO didn’t get very high in that spike, only 26.6 on close, it did generate enough fear to rebalance sentiment. After that it took a couple months for this fear to eventually bleed off as represented by the gradually-dwindling VXO in early 2010. The VXO wasn’t deep into its danger zone again until April, which also marked a major interim high just before the biggest selloff (and only correction) of this entire bull.

Last spring the SPX plunged 16.0%, a major correction. Greed and complacency were simply too high to be sustainable in late April when the SPX topped. These emotions make traders forget how stock markets truly behave, how risky they really are. Everyone interested in buying anytime soon is seduced into deploying their capital near the top, exhausting buying interest and leaving only sellers. At that point it doesn’t take much of a catalyst to ignite selling pressure, driving the sentiment pendulum back down into its arc.

Before the dust settled in that selloff, the VXO had shot up as high as 45.3 on an intraday basis and 43.6 on close. During that correction, it closed above 30 on 18 out of 49 trading days. This correction was so thorough in wiping out the greed and complacency plaguing the markets at the preceding interim high that the VXO didn’t return to its danger zone again until the end of 2010. Fear bleedoffs after sentiment-rebalancing selloffs are slow and gradual, it takes months before traders forget the selloff trauma.

And the reason fear continued dwindling is the SPX surged a whopping 28.2% between late August and mid-February! Such a gigantic upleg in less than 6 months annualizes to a massive 59% gain rate, which is enormously fast and unsustainable for the stock markets as a whole. Yet over this entire span, there was just a single minor pullback in November. At 3.9%, it barely even rounds up to the 4% minimum for declaring an actual pullback! With such a big and uninterrupted rally, it’s no wonder greed flourished.

By early February the VXO had drifted down to 13.7, representing extreme greed and complacency. No one was the least-bit worried the stock markets would weather a selloff anytime soon. But as always when hubris peaks, the selling came right when the majority of traders least expected it. And provocatively, well over half of this 6.4% pullback had already occurred before the Japanese earthquake! While that event accelerated the selling briefly, it certainly didn’t initially trigger it.

In mid-March when the earthquake tsunami’s nuclear fears peaked, the VXO only hit 31.1 intraday and 28.9 on close. This fear spike was very small compared to that seen last spring during the only correction of this bull, when the VXO blasted over 50% higher. And unlike in that correction event, in the recent March pullback the VXO closed above 30 on zero days. The stock-market selling didn’t get big enough to generate any meaningful fear, meaning the excessive greed wasn’t rebalanced away.

A confirmation of this was the near-record fast bleed in the VXO during that late-March SPX bounce. Instead of taking months to drift back down into its danger zone like it does after a rebalancing, the VXO plunged back down under 17 within a couple of weeks. This minor fear spike was low and short-lived, the SPX is going to have to see a lot more selling (and likely a real correction) to drag herd psychology back into line again.

The VXO’s rapid bleedoff also confirmed the total lack of lingering fear. This original-formula VIX has been around for almost two decades and has been back-calculated to 1986. In its entire quarter-century history, it has only seen three other comparable episodes where it fell about 40% in such a short period of time. They were just after the 1987 stock-market crash, the 1998 financial crisis, and the 2008 stock-market panic!

Of course all of these major once-a-decade crises drove massive fear spikes far beyond anything we’ve seen in the past couple years’ cyclical bull. So fast fear bleeds after these crazy extremes make sense. But to see one of these exceedingly-rare and atypical fear bleeds after mid-March’s minor VXO spike is amazing. It really highlights that traders were so greedy and complacent even after that March pullback that they quickly forgot the stock markets are at risk of correcting. There was no real fear, hence no sentiment rebalancing.

Remember corrections exist solely to rebalance sentiment. And once the sentiment pendulum starts swinging from one extreme to the other, it doesn’t stop until it hits the opposite extreme. Thus the weird VXO profile (minor spike, short-lived, near-record speed of fear bleedoff) argues that the brunt of this SPX correction is still yet to come. Traders remain very greedy and hyper-complacent, not the least-bit worried about a correction.

Well before that fizzled March pullback, other sentiment indicators shared the VXO’s warning of an imminent correction. One was the S&P 500’s Bullish Percent Index. It shows what percentage of these elite stocks are currently exhibiting technical buy signals on their point-and-figure charts. When this percentage gets high, greed and complacency are extreme. When it is low, fear reigns.

Back in mid-February at the SPX’s latest interim high, and the first peak of what now looks to be a double top, the SPX BPI edged up to a staggering 89.2! Over 89% of these 500 stocks had such bullish charts that they were flashing point-and-figure buy signals (these charts are always either buys or sells, there is no ambiguity). Note that similar 80s highs were seen at the past major toppings before the biggest pullback and only correction of this cyclical bull.

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