Stay cautious, but wait for the break

In Free by Cam Hui

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Mid-week market update: Markets behave different at tops and bottoms. Bottoms are often V-shaped and reflect panic. Tops are usually slower to develop. Hence the trader’s adage, “Take the stairs up, and escalator down.”

I have been writing that the US equity market appears to be extended short-term and ripe for a pullback, but that was last week and about 1% lower (see Why the S&P 500 won’t get to 2400 (in this rally)). I stand by those remarks.

I could say that the Fear and Greed Index appears to be extended and historically stock prices have had difficulty advancing further with readings at these levels.
 

 

I could also say that Ned Davis Research Crowd Sentiment Poll is also extended. Historically, stock prices have exhibited a negative bias at these levels (via Tiho Brkan).
 

 

None of this matters much to short-term traders. That’s because sentiment and overbought/oversold indicators are less useful at tops than bottoms. While it may be timely for traders to tilt to the long side when panic starts to appear, market euphoria are not good trading signals of market tops. Savvy traders know to wait for a bearish break when the market gets overbought and giddy.

I am seeing some limited signs of a bearish break, but the trading sell signal is incomplete.

CBOE put/call sell signal

I recently highlighted the euphoric condition where the CBOE equity-only put/call ratio (CPCE) had fallen to below 0.60 for four consecutive days. A study showed that such overbought conditions resulted in subpar returns, but they were still positive.
 

 

The same study showed that when the market becomes overbought and mean reverts, CPCE rises above 0.60, forward returns tend to far more negative. That`s the bearish break that traders should be waiting for.
 

 

The signal appeared as of Tuesday’s close, when CPCE rose to 0.61 and Wednesday’s preliminary equity put/call ratio came in at 0.82. Those are sell signals.
 

 

Still waiting for other breaks

While the CPCE sell signal is encouraging for the bears, other short-term technical indicators have not flashed signals for my inner trader to commit funds to the short side. I am waiting for the SPX to fall below its 5 day moving average, which currently stands at about 2355. In addition, I am waiting for RSI-5 and RSI-14 to decline below 70 as signs of faltering momentum.
 

 

I would add that my cautiousness is tactical. Any pullback should be regarded as a correction within an uptrend unless proven otherwise.
 

 

My inner investor remains bullishly positioned. My inner trader is in cash, but he is waiting for a technical break to go short.

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