Secondary indicators can be a useful tool in helping investors gauge market activity. The three main secondary indicators include the VIX, Bulls vs. Bears, and the put/call ratio. While it is important to track these indicators regularly, they are most useful in identifying bottoms in the market rather than tops. The reason for this is that tops in the market tend to form when the crowd becomes complacent—a longer term emotion. Conversely, bottoms occur due to fear, which happens to be reflected in the market more immediately. The fact that fear is more intense in nature affords us the ability to identify extreme readings in our secondary indicators.

 

The VIX is a popular measure of the implied volatility of S&P 500 index options. Since the VIX (0VIX) is range bound the majority of the time, a break out of its range with extreme readings (over 20 the last few years) could signal extreme fear in the market. Remember that bottoms occur when the majority of market participants are fearful.

 

The Bulls vs. Bears reading is a market sentiment indicator that uses information polled directly from market professionals. The indicator can be found in MarketSmith by going to any of the major indices, clicking the Related Information panel, and then finding the Climate tab. The indicator is used in a contrarian manner. Meaning that when market professionals are overly bullish, it could mean that the market is vulnerable, and when the majority of professionals are bearish it could mean the market is close to a bottom.

 

The put/call ratio measures the actual trading volume of put options to call options. Again, we want to be looking at an extreme reading toward bearishness, or in this case puts when looking for bottoms.

 

The recent intermediate correction is a great example of how secondary indicators could have been advantageous. At the bottom, the put/call ratio spiked, and bears outweighed bulls among market professionals, a very rare occurrence. Perhaps the most notable observation one could make by going back in the charts was the spike in the VIX. The VIX spiked up to levels not seen since the 2008 financial meltdown!

 

It is important to remember that these are in fact SECONDARY indicators and should be used as such. They are not perfect; however they can clue us in that a potential bottom is on the horizon. Many times an extreme reading will occur and the market will need to back and fill for a few months as it did in 2008. Being mindful of that, we always want to be focused on looking for a follow-through day to guide us into the market. Secondary indicators can then be used to watch sentiment and psychology further.

 

Best Returns,

 

Andrew Rocco,

The MarketSmith Team