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SPX Correction Looms 2

CPA, Principal & Co-Founder of Zeal LLC
April 15, 2011

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.

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.

After that early-2010 pullback, the SPX BPI hit the mid-60s before bouncing. And in the far-more-severe spring correction, it plunged to the high 30s. These are true bottoming levels, a high-probability-for-success buy zone defined by extreme fear. In mid-March during that recent pullback though, the lowest the SPX BPI went was merely the low 70s. This was far too high for a major bottom and portrayed a near-total lack of fear. And by this week, the SPX BPI had already bounced back into the low 80s again nearing its pre-correction danger zone.

The fear bleed as measured by the SPX BPI was way too fast as well. Coming from such a low-fear base, the only explanation is March's minor pullback didn't generate much fear. A final indicator concurs with this assessment, the 21-day moving average of the Put/Call Ratio. Traders bet on falling stock markets by buying put options, the right to sell at a certain price. So until the PCR 21dma gets over 1.00, meaning traders are buying more puts than calls, there really isn't any serious fear.

Before major selloffs, the PCR 21dma falls into a danger zone around 0.78 or so. This happened early in 2011. The latest March selloff merely drove this indicator up to 0.94. There was so little fear out there that traders were still buying more calls, bets on rising prices, than puts! This behavior is typical of minor pullbacks, but not the major corrections the SPX needs to experience after such a long, uninterrupted run higher.

Can the stock markets power higher indefinitely without a correction? Can the SPX continue advancing at its blistering 59% annualized pace? Not a chance. Extreme greed and complacency can't persist for long. And once the sentiment pendulum starts swinging the other way, like it appeared to in early March, it isn't going to stop until the opposite extreme is hit. And only a full-blown correction can generate the extreme fear necessary to achieve this.

So odds are a correction still looms for the overbought stock markets. The early-March selling was a start, but it fizzled out prematurely. The earthquake is to blame for this, by the way. Most of that pullback happened before the quake hit, but once it did traders latched on to it and used it as an excuse to sell. But like all news, this story's impact had a short half-life. As the shock of that event rapidly abated, so did traders' fear. But it was premature as that selloff hadn't yet come close to rebalancing sentiment.

A new SPX correction has critical implications for traders. Not only will all stocks get sucked into this selling, but commodities will too. The state of the stock markets affects sentiment universally, coloring psychology in unrelated markets. Futures traders tend to buy commodities when the stock markets are rising, the risk-on trade. And they tend to sell commodities when stock markets are falling, risk-off. Rising stock markets make them believe the economy, and hence commodities demand, is improving (and vice versa).

Consider this recent precedent. In the 6 trading days leading into and the 6 trading days after that recent mid-March stock-market low, the SPX performance ran -4.9% and +4.2%. Over these identical spans, commodities were slaved to the stock markets because of their psychological impact on futures traders. The CCI commodities index ran -6.7% and +5.5%, oil -6.1% and +7.1%, gold -2.2% and +2.3%, and silver -5.1% and +8.8%. Commodities and commodities stocks always get sucked into, and usually amplify, stock-market selloffs.

The swinging pendulum of stock-market sentiment is so powerful its influence spills out everywhere else. Commodities stocks in particular are sold hard, they are risky bets that are dumped rapidly when SPX selling frightens traders into reducing their risk. And the parallel commodities selling serves to intensify these commodities-stock selloffs, it gets ugly in a stock-market correction. Recently I did a couple studies looking at exactly howsilver itself and precious-metals stocks have performed during all of this SPX bull's selloffs.

On the bright side, the necessary and healthy stock-market corrections lead to the best buying opportunities ever seen within ongoing bulls. So when the correction risk runs high like it does today, prudent traders are raising cash and fleshing out their shopping lists. One sector high on my to-buy list after a falling SPX hammers it down again is junior gold stocks. We recently completed a big 3-month deep-research project looking into these high-potential companies.

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The bottom line is the unsustainable sentiment imbalances that existed before the March pullback still persist. That selloff was so minor and short-lived that the extreme greed and complacency generated by a massive and uninterrupted stock-market upleg were barely dented. Until this greed is bled away, and the quickest and surest way is through enough selling to finally generate fear, the risk of an imminent stock-market correction remains high.

But corrections offer the best buying opportunities seen within ongoing bull markets. So traders should eagerly anticipate the sentiment pendulum swinging back the other way, not ignore or fear it. Commodities stocks are particularly sensitive to stock-market selloffs, their losses will really leverage the general-market ones. This is due to their perceived riskiness as well as the parallel selling in commodities a stock-market selloff ignites.

Adam Hamilton, CPA

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Adam Hamilton, CPA, is a principal of Zeal LLC, which he co-founded in early 2000 as a pro-free market, pro-capitalism, and pro-laissez faire contrarian investing and speculating Information Age financial-services company. Hamilton is a lifelong contrarian student of the markets who lives for studying and trading them.

In 1933 President Franklin Roosevelt signed Executive Order 6102 which outlawed U.S. citizens from hoarding gold.
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