A Sell Signal Worth Paying Attention To

If the last fifteen years in the stock market has taught investors anything, it is that managing risk is a vital part of the game.

Given that (a) the bear markets of 2000-02 and 2008-09 both produced declines in excess of 50 percent and (b) a loss of 50 percent requires a gain of 100 percent in order to fully recover, investors learned that the "mathematics of loss" can be brutal.

In the rip-roaring days of the late 1990's, the game was about making as much money as possible. As such, risk management wasn't a concept on most investors' radar screens. However, the two brutal bear markets that occurred within the first nine years of the new century changed all that.

Investors Concerned About The Return Of "Their" Money

Nowadays, everyone is more concerned about the return "of their money" than the return "on their money." Sure, the gains from the bull markets are nice. But what folks really want today is to avoid getting smoked the next time the bears come around. And if ten investors were surveyed as to whether or not they think another next bear market is close at hand, at least seven will likely answer in the affirmative.

So, the question then becomes one of how do investors manage the risk in the stock market? Do they simply avoid the market altogether? Do they continue to play the buy-and-hope game? Do they diversify across asset classes, across time-frames, and methodologies? Do they try to hedge positions? Do they dollar-cost average in during declines? Or do they try and find indicators to get them out of market when risk rises?

Using Indicators To Identify High Risk Environments

Today's missive will address the last option: trying to find indicators that tell investors when it is time to take risk off the table. To be sure though, one of the most difficult things to find in the stock market game is an indicator that is consistently accurate. However, such indicators do indeed exist.

The first caveat to discuss is the fact that no indicator is perfect. Understand that no indicator gets every move right and that all indicators give false signals from time to time. In addition, investors should realize that an indicator doesn't always give signals that work in both directions (i.e. an indicator that provides a solid sell signal may not be produce good buy signals). And finally, it is important to recognize that every indicator ever dreamed up has an inherent flaw or two.

A Sentiment Indicator Worth Watching

Although market sentiment indicators are often misunderstood (remember, everyone can't be a contrarian!), there is one indicator that investors may want to follow consistently. In short, the indicator provides sell signals that tend to be long-term in nature and have been accurate 87 percent of the time.

The indicator utilizes the Investor's Intelligence sentiment data. Each week, the Investor's Intelligence survey indicates the percentage of respondents that are bullish, bearish, and expecting a correction.

In order to generate the indicator, one needs to take the ten-week average of the number of bulls divided by the sum of the bulls and bears.

Using The Indicator

Since 1970, when the 10-week average is above the 69 level, which indicates that respondents are overwhelmingly bullish, the DJIA has lost ground at an annualized rate of -1.0%. In short, when the indicator reaches that extremely bullish zone, it suggests that most of the market's buying power may have been exhausted. However, that's not the sell signal.

One of the best ways to use this indicator is to first wait until a bullish extreme is signaled (via readings over 69) and then reversed (via a drop in the indicator reading back below 67). This means that investors have first become extremely bullish over a long period of time and then the sentiment has reversed. It is the reversal that is key - and THIS is when the sell signal is given.

A Record of Strong Calls

Prior to Monday, October 7, this indicator has issued fifteen sell signals in the past forty-two years. Thirteen of those fifteen signals have been correct, meaning that the stock market declined subsequent to the signal being given.

The key to this indicator is a sell signal was flashed BEFORE (often well before) the big declines seen in 1974, 1977, 1984, 1987, 1998, 2008, and 2011. As such, when this indicator flashes a sell, it is a good idea to at least take note.

A Fresh Sell Signal

The reason this indicator is being reviewed this morning is it flashed a fresh sell signal on Monday with a reading of 66.9. Sure, it is a very close call, but it is a sell signal just the same. In essence, this means that investor sentiment has reached an extreme and is now reversing. And in the past, this has been an indication of trouble ahead.

Will the indicator be correct this time around? Has the mess in Washington artificially impacted the indicator's readings over the past month? Is this the time to sell everything and head for the hills?

Frankly, a healthy dose of hindsight is needed to answer the questions posed above with any degree of accuracy. However, this indicator appears to be suggesting that, at the very least, it is time to take some risk off the table and/or play the game more conservatively. And while using a single indicator in a vacuum is never a good idea, investors may be well served to at least be aware of what this indicator is saying.

Oh, and by the way, this indicator is published weekly (usually on Wednesday's) on StateoftheMarkets.com

Click Here For More "Daily State of the Markets" Commentary

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

1. The Games Being Played in Washington (I.E. the Gov't Shutdown and Debt Ceiling) 2. The Outlook for the U.S. Economy 3. The State of Fed Policy 4. The State of the Earnings Season

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Negative (Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Slightly Positive (Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive (Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

Near-Term Support Zone(s) for S&P 500: 1640
Near-Term Resistance Zone(s): 1680

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

Trend and Breadth Confirmation Indicator: Neutral
Price Thrust Indicator:Moderately Negative
Volume Thrust Indicator:Moderately Negative
Breadth Thrust Indicator:Moderately Negative
Bull/Bear Volume Relationship: Moderately Positive
Technical Health of 100 Industry Groups: Moderately Positive

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

Overbought/Oversold Condition: The S&P 500 is very oversold from a short-term perspective and is slightly oversold from an intermediate-term point of view.
Market Sentiment: Our primary sentiment model is negative .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward because different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Markets Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.

Weekly State of the Market Model Reading: positive

If you are looking for a disciplined, rules-based system to help guide your market exposure, check out The Daily Decision System.

Turning To This Morning...

Although there are other stories around the globe, the key focus in the market continues to be the happenings in Washington D.C. as politicians continue to dance around a potential debt default. Today, some optimism appears to be returning as Republicans may be willing to raise the debt ceiling in exchange for future negotiations on spending. The latest is that a new round of talks is scheduled today between President Obama and House Speaker Boehner. Stay tuned.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets: - Japan: +1.12% - Hong Kong: -0.36% - Shanghai: -0.94% - London: +1.01% - Germany: +1.37% - France: +1.45% - Italy: +1.78% - Spain: +1.78%

Crude Oil Futures: +$0.34 to $101.75

Gold: -$4.70 to $1302.50

Dollar: lower against the yen, euro and pound.

10-Year Bond Yield: Currently trading at 2.705%

Stock Futures Ahead of Open in U.S. (relative to fair value): - S&P 500: +13.60 - Dow Jones Industrial Average: +116 - NASDAQ Composite: +26.5

Thought For The Day...

"To err is human, to blame it on somebody else shows management potential" -- Unknown

Looking for Guidance in the Markets?

The Daily Decision: If you want a disciplined approach to managing stock market risk on a daily basis - Check the "Daily Decision" System. Forget the fast money and the latest, greatest option trade. Investors first need is a strategy to keep them "in" the stock market during bull markets and on the sidelines (or short) during bear markets. The Daily Decision system was up 30.3% in 2012, is up more than 25% in 2013, and the system sports an average compound rate of return of more than 30% per year.

The Insiders Portfolio: If you are looking for a truly unique approach to stock picking - Check out The Insiders Portfolio. We buy what those who know their company's best are buying - but ONLY when they are buying heavily! P.S. The Insiders is up over 30% in 2013 and has nearly doubled the S&P 500 since 2009.

The IRA/401K Advisor: Stop ignoring your 401K! Our long-term oriented service designed for IRAs and 401Ks strives to keep accounts positioned on the right side of the markets. This is a service you really can't afford not to use.

The Top 5 Portfolio: We keep things simple here by focusing on our five favorite positions. This concentrated stock portfolio employs a rigorous custom stock selection approach to identify market leaders. Risk management strategies are built in to every position.

All StateoftheMarkets.com Premium Services include a 30-day money-back guarantee!

Got Research?

Remember, you can receive email alerts for more than 20 free research report alerts from StateoftheMarkets.com including:

State's Chart of the Day - Each day we highlight a top rated stock with a positive technical setup.

The Risk Manager Report - Stay in tune with the market's risk/reward environment.

The 10.0 Report - These are the REAL best-of-breed companies.

The Insiders Report - See what the people who know their company's best are buying.

ETF Leaders Report - Looking for the top performing ETF's? You've come to the right place.

The SOTM 100 Portfolio - The top rated stocks in each market sector.

State's Market Models - Each week we quantify the "state of the market" with a series of models.

The Focus List - Think of the focus list as your own private research department. We do all the work and highlight our top picks each trading day

Mission Statement

At StateoftheMarkets.com, our goal is to provide everything you need to be a more successful investor: The must-read headlines, market commentary, market research, stock analysis, proprietary risk management models, and most importantly actionable portfolios with live trade alerts.

Finally, we are here to help - so don't hesitate to call with questions, comments, or ideas at 1-877-440-9464.

Wishing you green screens and all the best for a great day,

David D. Moenning Founder and Chief Investment Strategist StateoftheMarkets.com

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

Positions in stocks mentioned: none

The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of TopStockPortfolios and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

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