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Saturday, November 12, 2011

Yet another reason why I don't think we saw 'the' top (3)

Third installment in the series of reasons why I don't think this cyclical bull market is done.

-- Yet another reason why I don't think we saw 'the' top, Sept 2011
-- Yet another reason why I don't think this cyclical bull is over, Aug 2011

This observation is not as strong as the other two, since it is based on only a few data points (due to lack of data history). So while it is not a standalone observation, it is supportive of the previous two posts above.

I am talking about the Equity Put/Call Ratio.

Like the VIX, the CPCE is an inverse indicator, which means as the market goes up these tend to move down. So in order to use these like indicators to find divergences, they must be inverted. This is what is shown in the chart below.

Now this chart cannot be taken at full face value. The CPCE has only a few years of history (at least in Stockcharts) and we can see below that as far as 'major' turning points go we can only see the behavior at the 2007 top and 2009 bottom. Hardly statistically significant. But where this is valuable is how it can be used as a confirming indicator to support the VIX.

But this type of analysis also has intuitive usefulness. We see over and over again that fear tends to spike on the really deep plunges in the market, and that while fear is still high on the subsequent move down, it is less in magnitude. The opposite is true on rallies. The strong rallies are borne out of doubt and takes people by surprise. The correction after a very strong rally is when the crowd jumps in and the next run is usually less dynamic.

This emotional content of the herd mentality is captured in both the VIX and CPCE. And looking for when the CPCE and VIX move together and when they diverge reveals interesting behavior.

Also looking at the bullishness peaks throughout the series: When bullishness is at a spike peak, that has not signified the market top. In fact the CPCE registered much more bullish readings in 2004-2006 before the final price peak in 2007. From this perspective, the cyclical bull market did not end until the market 'tired itself out' from bullishness.

A similar analogy can be made for the peak in May of this year, which had a very bullish CPCE spike. We have seen several extreme bullish readings on the rally since 2009. But we have not yet seen a 'tired peak' with confirmed VIX divergence to signal a major top.

Addendum 4:05 pm 11/12/2011

Here is another way to think about the patterns that the CPCE has been showing us thus far. For more on my secular bear market projection, see these posts:

-- First Derivative of the S&P 500, Long Term Study
-- Real Secular Bear Markets
-- Secular Bear Market Projection in Historical Context
-- Bear Market Momentum Internals: Examination of Moving Average 'Price Stretching'

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