Money & Finance - Warning! Coming Market Correction.

Thus far for the month of October the U.S. equity market looks somewhat weak. That said, our quantitative behavioral model continues to produce a “buy” signal albeit a very weak buy.  If our behavioral model registers a “sell” signal in the near future, we will be liquidating our remaining long positions and will take a short position against the market into the final quarter of the year.

Here are a few items that we have been tracking recently that signal further market weakness may be on the horizon.

Put / Call Ratio

The put/call ratio is the comparison of put volume relative to call volume. For those unfamiliar with how put and call options work, put options are derivative securities that move in the opposite direction of its underlying asset. For instance, if one were to purchase a put option against the S&P 500, if the index went lower, the put option would appreciate. Put options are generally used to hedge against market weakness or bet on a decline. 

Call options are just the opposite. Unlike put options that have an inverse relationship with its underlying asset, call options have a direct relationship with the underlying. Call options are used to hedge against market strength or bet on advance. A put/call ratio above 1 signifies put volume exceeding call volume. When the ratio is below 1, then call volume is greater than put volume.

The theory goes is that when the put/call ratio is registering high numbers (in excess of 1.0), market sentiment is deemed bearish. If this ratio stays elevated for a period of time, one would look for clues of an oversold “skittish” market and would consider buying stocks. Conversely, when the ratio is nearing excessively low levels for a period of time, one would determine the market as too “complacent” and look to exit. 

Observing figure 1, one can see the daily tracking of the put / call ratio for U.S. equities. We are seeing a new uptrend in this ratio. After a period of complacency, the put / call ratio has been above 1.0 for the past week. This may be indicating some renewed “fear” entering the market. A continuation of this upward trend will surely indicate further market weakness.

Volume Indicator

We at JSK Partners have several proprietary models that we use to help navigate the market. One such model is our Volume Indicator. This model accounts for strength or weakness in market direction based on the amount of volume during the trading day.

More specifically, if the market is going higher but on declining volume, the bullish score will start to weaken, many times before stocks start to head lower. Separately, if the market is selling off on declining volume, the bullish score will start to strengthen, many times before stocks start to head higher.

This model is included in our overall behavioral model, but given the readings that we are collecting; we thought it wise to single out this model. When our volume indicator reaches a level of 105, which is one standard deviation from the mean, this is typically a warning sign that the market may experience some near-term weakness. As of the last four weeks, our model registered a high of169 and has trended lower since. We consider this a flash warning to be weary of the declining strength of this rally.

We are getting multiple signs of caution that the market may experience temporary, near-term weakness. Stay prepared to adjust your portfolio accordingly.

 

NASDAQ relative underperformance

We continually look for clues as to market direction and guidance on how to proceed. One concerning trend recently has been the relative underperformance of the NASDAQ relative to the S&P 500. It would appear the general investment pattern over the past month has been one of caution as market participants focus on deteriorating US economic trends, increased fears of Armageddon from Europe, the pending fiscal cliff and weak corporate earnings. The NASDAQ has been the index that has led on the way down.

Figure 5 compares the performance of the S&P 500 vs. the Nasdaq. When the slope of the two lines are heading lower, that means the NASDAQ is underperforming the SPX and we will remain in a market down trend.

 

Bottom Line: We attempt to take the emotion out of the investment decision making process by following the mathematics. While we continue to hold a long position in the market, one can easily find chinks in the armor in this rally. We are prepared to adjust accordingly should the market take a turn for the worse from these levels.

-Joseph S. Kalinowski, CFA

Twitter: @jskalinowski

 

JSK Partners of New York, LLC
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