Market Flashes Yellow Caution Light

Over the past few weeks, we have mentioned several indicators which we described as “very early warning signs.” Specifically, we have noted the ever lower VIX as a sign that the investors were starting to get complacent. The VIX made yet another 52-week low yesterday, closing at 14.34. In our opinion, the slide lower will continue until we see a healthy correction. We do not pretend to know precisely when that may occur. However, we see a realistic possibility of strong corrective action occurring during the next 90 days, very possibly sometime in mid February.

This is not exclusively – or even mostly – a VIX call. Several other sentiment measures have also caught our attention. We noted the stunningly low 10.11% Bearish sentiment amongst AAII survey takers previously. That is significant because of the investor tendency to become bullish after buying equities – not before. So few Bears around make us wonder who else is left to be “converted” into buyers.

Yesterday, yet another signal caught our attention: The Put/Call ratio. As measured by the CBOE, the ratio dropped to 0.33 on January 21, 2004*. We have not seen a data point that low since 12/26/97, when the ratio registered a mere 0.30 following the Asian currency crises (precipitated in large part by LTCM). The last period with a data series between 0.35 – 0.40 was during February to July 2000. You may recall the subsequent period as somewhat uncomfortable for those who were exclusively long.

There is a stark difference between bottoms and tops. At bottoms, shareholders become collectively disgusted with their losses, cathartically heaving shares overboard. Tops are entirely different animals, as wannabe shareholders continue to pile on, late to the party. Assessing tops is more difficult, as one can never be sure how much “dry powder” buyers potentially have. Their ardor is why markets can continue to look healthy, despite contrary warning signs. As we have mentioned previously, the internals of this market have been strong, particularly when viewing Trend and Breadth. We do not feel it is prudent to ignore the flashing warning signs we see in these contrary indicators.

Guessing market tops has been a fool’s errand. But that does not mean we should ignore the warning signs. For those who are long, we offer the following advice:

1) Move up your stop losses;
2) Observe the 25% profit rule: Sell any position where you “give back” 25% of a stock’s gains (i.e., if you bought a stock at 40, and it went to 60 (a 20 point profit), once you give back 5 points, protect the rest of your profits by selling;
3) Buy protective Puts 6-12 months out for your long term or core holdings;
4) Reduce your margin as close to zero as possible.

For those of you who are short: let ‘em ride.

* NOTE: CBOE data comes out weekly, and our series used ILX as a data source for the 1/21/04 put call ratio. Mixing data sources is considered to be bad form by quants and statisticians; We will monitor this and report back if the CBOE data is any different from ILX . . .

CBOE February 2000 put call ratio data series is here:

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