Additional cautionary signs for the market. Getting ready for the big short...

Regular readers of our blog will know that we have become a little more cautious in recent weeks as the market has had a storming start to the year. Almost all our picks - ENRC, Bumi, LMI, Japan, GBPAUD, Apple etc have been major outperformers and good profits have been reaped.

Well below is a chart of the S&P 500 together with the difference between the percentage of bulls and bears, according to the weekly sentiment survey by Investors Intelligence (II). When the number of bulls is far higher than the number of bears, it’s an indication of a lot of optimism in the market. We can see below that the high levels of optimism have, historically, had bearish implications for the market going forward. Certainly this was the case looking at 2011 and 2012.

Six weeks into 2011, the bulls-minus-bears was very near 40% (circled on the chart) - an extreme measure. The market went sideways after that, before eventually collapsing later in the year and giving back all its gains. Then, in 2012, the market was once again off to a great start, but this time the bulls-minus-bears was much less, right around 20%. The market continued higher and finished the year up about 13%. Currently, the optimism, according to this poll, is the near the 2011 level (marked by the red line). Any further strength going into this weeks expiry of options in the US will be our cue to get aggressively more short (thus far we have been playing it via Put Spreads centred around March and April expiries).

The expiry this week has a lot of open call options around the 1520 level - sellers of these calls will be keen to keep a lid on prices below this level so that they can collect the premium. If however there is a move through here then what is called “delta hedging” will come into play and they could force the market up quite sharply - perhaps towatds 1540. If this occurs going into the close of play Thurs/Fri morning then we will be selling short heavily.

 

Going back to 1990 and looking at those years when the S&P 500 was up at least 2% through the first six weeks of the year and tracking the returns going forward depending on whether the bulls-minus-bears was above 20% or below 20% is displayed in the table below. We can see that the returns are remarkably better when there is less optimism in the market. This is one indicator showing some cause for concern as the market is closing in on all-time highs.

 

Below is a cracking guide that we put together that looks at a possible end date for the current bull run, and also postulates upon the ideal level for one to get long on any imminent correction to capture the last of the returns from this bull market.