Market Breadth Divergence Update

On Sunday November 17th, I posted an article that identified headwinds for the equity market.  I explained that five independent leading indicators all pointed to near-term trouble for equities: a forming divergence in market breadth, an elevated CBOE Skew Index, a very low gamma-weighted Put/Call open interest ratio, an overvalued Price/Sales ratio and a plethora of overly bullish sentiment measures.  The additional week and a half of data sheds some additional insight on the market breadth divergence and the other four leading indicators.

Market Breadth Divergence

If you would like to learn more about market breadth, please revisit one of my favorite articles “The Secret Weapon of Technical Analysis.”Bearish divergences occur when a price series reaches a new high and the predictive indicator does not.  I recently wrote about the predictive power of double divergences in an article titled “The Deadly Double Divergence.” However, the divergence I discussed in last week’s article titled “Five Headwinds for Equities” was a single divergence and it was still in the process of forming.

Figure 1 below is the chart I published in last week’s article.  It includes the daily candlestick chart of the S&P 500 index and the cumulative advance-decline line for the combined NYSE, AMEX, and NASDAQ exchanges through 11-15-2013.  As of the 15th, the S&P 500 had made another higher high, but the cumulative advance-decline line was still well below its prior high, although it was still climbing.

Figure 1: Forming Divergence 11-15-2013

Figure 1: Forming Divergence 11-15-2013

Figure 2 below is the same chart as Figure 1 above, but it has been updated through the close on 11-27-2013 (based on preliminary data). As you can see from the chart, the cumulative advance-decline line pulled back significantly after 11-15-2013, forming a lower high, which completed the bearish divergence.  However, since the bearish divergence, market breadth has resumed climbing, as has the S&P 500 index.  If the cumulative advance-decline line surpasses its previous high from late October 2013, that would negate the bearish divergence signal.  One more solid up day on Friday would probably do it.  It will be interesting to watch.

Figure 2: S&P 500 Divergence 11-27-2013

Figure 2: S&P 500 Divergence 11-27-2013

The CBOE SKEW Index

As I mentioned in last week’s article, when the CBOE SKEW index becomes elevated, the market-implied probability of a large adverse price move increases significantly.  The CBOE SKEW index was 133.46 as of 11/15/2013.  Over the last week and a half, the SKEW index has continued to fluctuate above the 130 warning level, which continues to suggest an elevated risk of a near-term pullback.  The longer the SKEW index remains elevated, the greater the risk.

Shaeffer’s Gamma-Weighted SOIR

The ratio of open interest in puts to calls in the SPY ETF has also proven to be a reliable indicator of overbought or oversold conditions in the equity market.  Shaeffer’s Gamma-Weighted SOIR goes a step further than a standard put/call ratio and uses the gamma of each option to assign weights to the put and call open interest values for each option.  When the SOIR is low (below 0.90), the market is excessively bullish and the risk of a pullback is elevated.

As of 11/14/2013, the SOIR was 0.79.  The SOIR dropped below 0.90 three other times in the past six months.  The first two instances led to rapid pullbacks.  The market consolidated for two weeks after the most recent occurrence. Since 11-15-2013, the SOIR only managed to rise above 0.90 on one day (0.91).  Most of the SOIR observations in the last week and a half were below 0.80 and two of those observations were in the low 0.70s.  The very low SOIR continues to suggest a near-term reversal.

Price-to-Sales Ratio

In May of 2013 I posted an article on the overvalued price-to-sales ratio (PSR) of the S&P 500 index titled S&P 500 overvalued based on Price-to-Sales ratio. At the time, the price-to-sales ratio of the S&P 500 was 1.53, which was approaching historical highs.  The PSR for the S&P 500 increased from 1.53 in May to 1.63 as of 11/15/2013 and has since risen to 1.64.  The PSR has not been this overvalued since the height of the tech bubble in 2000.

Market Sentiment

There are many different market sentiment indicators, most of which are contrarian in nature.  In other words, when the entire world is bullish, there is nobody left to buy and a market decline must be imminent.  I subscribe to Sentiment Trader, which aggregates, publishes, and analyzes an exhaustive list of sentiment indicators.  In addition, it is also possible for subscribers to download the historical data for many of their data series.  I aggregated several of their data series into a custom sentiment index, which I use directly in my systematic strategies.

Their data is not available without a subscription and I am not authorized to republish their charts or data.  However, I can confirm that the market sentiment data that I follow has become even more extreme since last week.

Conclusion

The equity market is both overvalued and overbought and market sentiment is excessively bullish. The bearish divergence pattern that was forming last week was confirmed late last week.  The recent rebound in market breadth may negate that signal, but all of the other indicators discussed in last week’s article are even more extreme.  The probability of a pullback has risen in the past week and a half.

Nevertheless, bull markets are notorious for continuing to climb in the face of overbought conditions, even when the market is overvalued and sentiment is excessively bullish.  After the euphoria of Thanksgiving week passes and month-end cash flows subside, traders may finally take a more realistic look at the market.

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About Brian Johnson

I have been an investment professional for over 30 years. I worked as a fixed income portfolio manager, personally managing over $13 billion in assets for institutional clients. I was also the President of a financial consulting and software development firm, developing artificial intelligence based forecasting and risk management systems for institutional investment managers. I am now a full-time proprietary trader in options, futures, stocks, and ETFs using both algorithmic and discretionary trading strategies. In addition to my professional investment experience, I designed and taught courses in financial derivatives for both MBA and undergraduate business programs on a part-time basis for a number of years.
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