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by Todd Bolen http://www.tradersedge.us One of our best calls this year was the October 10th, 2002 reversal that led to a 37% rise in the overall markets. What did we see that allowed us to make this call? To bring you back, from August 22nd through October 9th, the Dow was down 20%, the S&P 500 sold off 21% and the Nasdaq slid 22%. All the people on CNBC were talking about the end of the world and doom and gloom. You could not find anyone positive about the markets. However the indicators we follow were telling us the downward move was coming to an end. In its simplest form, sentiment indicators measure extremes in the market. When everyone is going one way, odds favor a shift in the opposite direction. The indicators we follow are the put/call ratio, newsletter writers, the VIX, the "magazine indicator" and NYSE vs. NASDAQ volume ratio. All of these indicators flash warnings signs at extreme levels in the market and give you a hint of the coming reversal. Put/Call Ratio Typically investors will buy call options when they are optimistic on the market. Conversely, they will buy put options when they anticipate it will fall. The put/call ratio measures the number of puts bought for every call bought. For example, when the indicator measures .67, this is telling you that for every 1 call that was purchased, .67 puts were purchased. This would tell you that generally, people are more bullish than bearish. When the put/call ratio spikes over 1.0, a warning flag is raised. This indicates more people are becoming bearish, which usually happens AFTER the big drop. It tells you the market is nearing extremely oversold conditions. The put/call ratio hit 1.12 on 9/18, 1.08 on 9/19, 1.05 on 9/20 and 1.0 on 10/9. Only two other times in 2002 did the ratio measure over 1.0! By following this indicator daily, you would have been alerted to the change in direction that occurred October 10th. Use the put/call ratio as a guide only. It is a SECONDARY indicator. In other words, just because the ratio hits over 1.0, don't buy the market like crazy. The indicator will give you a good idea of when the selling is nearing an end for the near-term, but not the exact point. Newsletter Writers Investors Intelligence is a company that tracks popular newsletter writers across the country. They originally thought if most writers were bullish, it would be a good sign to be in the market. After years of studying these writers, they found the opposite to be true. In other words, when most newsletter writers were bullish, the market soon thereafter fell. When most writers were bearish, the market soon rallied. So we watch the ratio of bullish to bearish newsletter writers to look for extremes. Let's look at some examples: ~ In 1987, 61% of advisors were bullish up into the crash in October. You know what happened next. ~ In 1990, during the recession, more than 55% of writers were bearish. The Gulf War started and the market had a tremendous run. ~ In 1994, right before the markets made another multi-year run, bearish sentiment was 59%. ~ In February 2001, after the huge drop in 2000, newsletter writers were still bullish. A full 62% of them, a 14-year high, expected the market to rise. They were in for another year of negative returns. ~ Care to guess were the newsletter writers were on October 9th, 2002? You guessed it, mainly bearish! Follow this number daily. These extremes do not happen very often, but when they do it is yet another quiver in your cap telling you the market is about to reverse. VIX Indicator The VIX is a measurement of volatility. Very simply, it measures the tone of selling which can get panicky near market bottoms. When the indicator moves above the 40, and especially above the 50 level, the market is very close to reversing direction. How did this indicator perform around October 9th? ~ 9/19 46.16 ~ 9/24 45.38 ~ 10/04 46.28 ~ 10/07 49.18 ~ 10/09 49.48 As you can see, the index started creeping up in late September and finally capped out around the 50 level. The selling was obviously extreme. Knowing this number, combined with the put/call ratio and the newsletter indicator would be a major indication to you the market was about to reverse. By the way, it hit 49.04 on 9/21/2001 right before the markets staged a major 30% comeback rally. Magazine Cover Indicator This indicator is more difficult to monitor but simply be aware of the covers on magazines. The writers report the news after the fact and are notoriously late. Once you start seeing bears on front covers and charts depicting crashes, simply be aware. The worst is probably over. The most famous example of this indicator is Business Week's article titled "The Death of Equities" which was published August 13th, 1973! NYSE vs. Nasdaq Volume You will notice around major market bottoms, the NYSE will trade many more shares than the Nasdaq. Why does this happen? When a bear market starts, investors will sell shares of more speculative companies first. Later in the process, they will come after the blue chip types of companies thus causing the volume to increase on the NYSE. The first time we saw this indicator pop up was on 9/24 about 2 ~ weeks before the reversal October 10th. It showed up again on 10/04, which was the highest level in over 5 years! It finally showed itself on 10/07 and 10/08. These were major clues of the coming move. Following these indicators daily will help you "feel" when the market is in extreme territory. You will be alerted before the crowds of the coming reversal and can position your portfolio accordingly. This article courtesy of http://www.investment-index.com. You may freely reprint this article on your website or in your newsletter provided this courtesy notice and the author name and URL remain intact.
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