Four Red Flags

Posted On December 8, 2014 10:14 am

These four indicators suggest the market could be vulnerable to a short term correction. 

I’m not a doom and gloomer. In fact I’m pretty bullish on the U.S. stock market over the next 12 months. But as an active trader I need to keep my antennae up for warning signs so I can sidestep losses. Or better yet, profit from potential declines. After all, forewarned is forearmed.

Recently I wrote how Warren Buffet was getting worried due to the unsustainable level of earnings versus GDP growth.   He’s a very long term investor and that indicator takes a very long term macro view; it may take months or even years to play out.

But right now there are four signals suggesting the market is vulnerable to a short-term pullback.

Put/Call Ratios

The put/call ratio, which measures how many puts are being bought versus call options, is a favored contrarian market sentiment reading.   A very high reading shows that more puts are being purchased than calls. This usually occurs during market declines as investors rush for portfolio protection. A big spike typically marks a bottom as a full panic sets in.

By contrast a very low reading suggest complacency. As you can see from the accompanied graph we are currently at a very low reading that has provided previous short-term sell signals.


When investors forgo put protection when the market is at all-time highs it is akin to a trapeze artist working without a net. He may not fall but if he does the results could be disastrous.

Bad Breadth

Even as the S&P 500 Index marches to a new high most individual stocks are not anywhere near highs, in fact the high/low picture keeps weakening from rally to rally and despite the steady close of the $SPX this week the highs/lows just kept shrinking:


With most stocks are lagging fund managers must play catch-up by chasing into a few select winners or opt to deploy cash into ETFs like the SPY which then favor those most heavily weighted stocks.   As a result you get new in the S&P 500 while the small cap Russell 2000 is actually down for the year So stocks like Apple (AAPL) are rallying a whopping 25% over the past month while the underlying base gets worn away.

There is only so long the generals can march forward without the support of the foot soldiers before they beat a hasty retreat.

High Yield Looks Junky

This next gauge may be a bit wonky but it is very reliable. It tracks the yield on junk bonds versus the S&P 500 stocks. It basically hopes to gauge the relative value of the two. In this zero interest rate environment investor are on the hunt for yield. High-yield bonds and equities are adjacent to one another on the spectrum of assets than run from safe to risky. So when one outruns another in a particular direction for a fair distance, money in aggregate seems to shift to bring them back into line.


We are at a level in which high yield or junk bonds offer a better relative value than stocks. Previous instances in which junk yields move to a premium to cash flow have led to short term set back in stocks.

V Bottom Run Its Course

Finally we come to the fact that stocks have simply come very far very fast and may need to rest.   Since the October 15th low the S&P 500 has galloped up 15% in just three weeks. While this type of “V” bottom has occurred before, and the magnitude of the rally is not unprecedented, it is pressing the limits of longevity.

Current V-Bottom

Out of the last 8 “V” bottoms the average gain above the old high has been 3.5%; we are now 3.2% above the previous high. The average length of the rally has been 35 days; we are now on day 38.   This rally is getting long in the tooth.

In summation, stocks can certainly continue to drift higher but the above data points suggests there is an increasing likelihood of a pullback.   It may not come before the holiday season but I want to be careful not to end up with a bag full of coal. I’m stepping aside and taking down my market exposure here.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.