Smart Investing Daily – Which Signals Tell You That the Market Is About to Drop?

Jared Levy, Editor, Smart Investing Daily
Tuesday, 08 March 2011

jared_levy150x150-2 One thing that has made Smart Investing Daily the fastest-growing e-letter in our history is you, our readers. We appreciate your attention, referrals to our letter and, most importantly, your questions! Keep them coming!

A couple days ago, I received an e-mail from Smart Investing Daily Reader F.R., who wrote:

I’ve been following your newsletters for a few months now and I must say they are very insightful. I read an article today and it quoted a guy from Agora Financial saying that since retail investors have piled a lot of money into mutual funds, coupled with the S+P rising by 100 percent and the spike in oil prices, all these are indicators that the market is due for a major pullback. So I guess the best strategy now is to probably identify possible shorts (Netflix anybody?) or put options? The question is… when should I be considering that the market will go down?

I would really appreciate some feedback on this. Wonderful job you guys are doing. Keep it up! — F.R.

F.R. asks a couple loaded questions that I thought would make for an excellent article. Let me address each separately and hopefully shed some light on these topics for you.

Retail Investors

The first statement refers to “retail investors” piling into stocks and mutual funds recently.

Retail investors, home gamers and self-directed investors all refer to anyone who is not an investment professional and generally doing their own research and buying and selling stocks and mutual funds on their own behalf, usually through a discount broker.

The unfortunate retail investor usually gets a bad rap and most times it’s for good reason. By the time data and market sentiment reach the masses and they are able to not only digest it, but finally act upon it, it’s often too late. Of course this belief may be contested, but many professionals share this opinion. The Internet and education are helping diminish this lag.

There are several indicators out there that allow us to see if money is flowing into or out of the financial marketplace as a whole. To find mutual fund data, you can look at the Lipper Fund Flow Report (paid service) to get an idea of how money is flowing in and out of funds.

Because mutual funds are in large part used by retail investors, fund flow data can be classified somewhat as retail activity. When retail investors move en mass, they are usually entering near the end of a trend or exiting before a new one starts. Some traders tend to view a huge jump in retail investor sentiment and inflows as the beginning of the end for a bull market.

Volume Trends

Volume trends should be observed when stocks are on the move. If a stock or index like the S&P 500 is moving higher and each day less and less volume occurs, chances are that the trend may be slowing or ending. If you look at the volume in the SPY from Jan. 31 to Feb. 18, you’ll notice a lower overall volume trend leading into the three-day correction. A useful tip is to use a five-day volume moving average to smooth out the noise.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

Abnormal Stock Movements & Correlations

F.R. noted that the S&P 500 was up over 100% from its March 2009 lows, which could mean that the market is overbought. When you’re trying to figure out if a stock is overbought, you have to look at several time frames and use some basic valuation measurements. Let me explain.

If I were to tell you that the market is up over 100%, without saying anything else, would you think that the market is overbought? Probably yes. What if I told you that it’s up over 100% in two years? Now maybe you’re a little less convinced. Now finally what if I told you that the market is up 0% in 12 years? I’m sure the last thing on your mind is that it’s overbought, but guess what… All of those statements are true!!

The S&P is just back where it was back in June of 1999… so is it cheap or expensive?

It’s all about the speed at which the market is moving and about how much money companies are making on average! This is why you must combine the price of a stock or index like the S&P 500 with some earnings data to really see if it’s relatively cheap or expensive! The P/E ratio is a great basic measurement, I wrote about it in a Smart Investing Daily article from mid-February.

Right now the trailing P/E ratio of the S&P 500 index is about 24, which is a bit high, meaning the index might be considered overbought. The average is about 15.

F.R. also mentioned the price spike in crude oil. Crude oil, energy and food spiking in value will not only increase your cost of living, but will also cost many companies money to make and deliver their goods and services, which makes for lower revenue and therefore lower earnings forecasts, which is why the market is moving lower on higher crude oil.

Short Interest and Put Options

There is much that can be written about these two topics, so I will be brief and cover them in the near future. I wrote a couple weeks back (before Netflix and the markets corrected) about a trend I was seeing in short interest and how I thought that we were going to see a sell-off.

Short interest is not easy to interpret and you should use caution when using it as a tool. But growing short interest can be an indicator of an increasing bearish sentiment.

Put options are much like short interest. An increase in the purchase of put options is essentially like taking a short position in a stock. Here too, you must be careful not to jump to conclusions unless there is a huge aberration, such as the continued purchase of an abnormal amount of put options bought in a stock.

I have been trading options for 18 years and it even takes me a while to interpret options action. This is simply because traders have different reasons for buying puts (or calls). Puts can be bought for protection against a catastrophic loss, and many hedge funds, mutual funds and professionals are always buying puts even if they are bullish.

I know it sounds nuts, but if you are long stock and purchase an out-of-the-money put, you are simply purchasing insurance. It doesn’t mean you want the stock to go to zero. All of you hopefully purchase insurance on your home, right? Do you want your home to be destroyed by wind, fire or water? Probably not…

At the end of the day, you need to keep yourself informed and buy quality stocks that have demonstrated good earnings power. If something doesn’t feel right, don’t be afraid to walk away. Right now, the markets don’t feel quite right to me… at least not until earnings season gives me some proof…

Editor’s Note: This tiny micro-cap is poised to soar and early investors could pocket as much as $97,500. The following investment market report will give you all the details. BUT you must act now to ensure your shot at maximum gains. Get the exclusive invesment report now.

Article brought to you by Taipan Publishing Group. Additional valuable content can be syndicated via our News RSS feed. Republish without charge. Required: Author attribution, links back to original content or www.taipanpublishinggroup.com.