Market sentiment is the crowd psychology of market participants and can help give investors a clue of the future direction of a market.
This article is published with permission from InvestmentU.com.
Market sentiment is the crowd psychology of market participants and can help give investors a clue of the future direction of a market. When markets are extremely frothy, sentiment will skyrocket usually prior to prices reversing and beginning to fall. When sentiment is extremely negative, and market participants believe the sky is falling, it is usually a precursor to a market that is poised to rebound.
With the S&P 500 index hitting all-time highs, investors should pay attention to sentiment indicators to see if the current outlook is too rosy. Here are three sentiment indicators that will help guide you through the current market environment.
The VIX is an implied volatility index published by the Chicago Board of Options Exchange. The index measures the implied volatility of the “at the money” strike prices of the S&P 500 index. Implied volatility is the market’s estimate of how much the S&P 500 index could move over a specific period.
Many view the VIX as the fear gauge. The higher the VIX the more market participants expect the S&P 500 to move, which generally reflects trepidation. When the VIX is at historically low levels, complacency is prevalent. The VIX is trading in the bottom 10% of the values seen over the past 10-years, which reflects a complacent market environment.
The Relative Strength index (RSI) is a technical indicator created by J. Welles Wilder. It measures the speed and change of price movements, and reflects sentiment as levels that are either overbought or oversold. Wilder defined overbought levels as RSI readings above 70, while oversold levels, which reflect negative sentiment, are RSI readings under 30. Currently, the RSI on the SPX is 65, which is at the upper end of the neutral range, and shows that sentiment is rising but not overbought.
The Put/Call Ratio is an index that reflects the put options volume of a stock relative to call options volume. The Put/Call Ratio produces readings below one when call volume is greater than put volume. The ratio level is above one when put volume exceeds call volume.
Sentiment on a stock is considered bearish when the Put/Call Ratio is trading at relatively high levels, and excessively bullish when at relatively low levels. The Put/Call Ratio can be measured over the past five years to calculate sentiment. When the Put/Call Ratio is in the bottom 10% of its five-year range, sentiment is complacent, and when the Put/Call Ratio is in the top 10% of its five-year range, sentiment reflects fear. At the time of writing, the Put/Call Ratio is in the bottom 15% of its five-year range, reflecting a neutral tone that is close to complacency.
What Does This Mean for Investors?
The three sentiment indicators reflect that the current market environment is closer to complacency than fear, but sentiment does not reflect extreme confidence. Investors who are looking to hedge their stock market exposure should monitor these indicators and be ready to act when sentiment becomes frothy. This means selling some stocks or purchasing put protection. Investors who are looking to buy should feel comfortable that sentiment is neutral, but might also consider waiting until sentiment becomes negative.
The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.