Fighting That Bearish Feeling

05/15/2013 9:00 am EST

Focus: MARKETS

Greg Capra

Co-Founder, MasterTrader.com

The stock market has been rallying since 2009 and while it would be normal to think this bull market could end soon, traders should guard against that belief, counsels Greg Capra of Pristine Capital Holdings, Inc.

Long before bull markets end and the majorities are jumping in, the markets reach a point where the advance has been ongoing and starts to become unbelievable. By unbelievable I don't mean that the markets aren't moving higher, obviously they are. What is unbelievable is that the advance continues as long as it has. Bull markets do end at some point, but not until the majority of investors and traders do believe completely. Let's monitor this.

At the start of a bull move, few believe it is because of the many failed rallies within the prior downtrend and the typical sharp, fast drops. Another reason is that as prices are trending higher, most traders and investors using technical analysis are caught up in the indicator-based method. As prices trend higher, the indicators give overbought signals that create a belief that prices have moved too far and have to correct. Well, in a strong bull market, corrections are typically shallow or even sideways. I like to tell students new to Pristine that ask about overbought readings, what is overbought in a bull market is going to get more overbought; forget the indicators, they are meaningless. What we do use are market internal breadth and sentiment gauges.

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In the above chart are the S&P 500 ETF (SPY) and the CBOE put/call ratio. Clearly, the trend is up and prices have moved further above the moving averages than they have in the recent past. For that reason, prices may move sideways or pullback a bit; however, just being further from the moving averages is only one piece of information and limiting its use on its own.

The other piece of information on this chart that we want to take note of is that option traders started to become more aggressive with their call buying (bullish bets) last week. While this increases the odds of the uptrend stalling, it won't be a signal of traders becoming too bullish until the five-period moving average (blue line) moves between the red lines. Option traders have a great record of getting fully committed to the market's trend at the worst possible time. For that reason, I keep an eye on their trading and suggest you do as well.

NEXT PAGE: Market Breadth Gauges

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For market breadth internal gauges, I use the two measures of advancing and declining stocks. The top is the McClellan oscillator, which is simply the difference between two moving averages of advancing stocks minus declining stocks. This gives us a short-term measure of when the broader markets (many stocks) have moved a bit too far. The lower is 21-period moving average of a ratio of advancing stocks divided by advancers plus decliners and an intermediate-term measurement.

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As you can see, both have moved to high levels. However, this isn't much of a concern at this time because those option traders we monitor have not jumped all-in yet buying call options. When they do, and these breadth internals are at high levels, history tells us that a correction within the bull market is close. That being said, it does not mean the end of the bull market. There are other factors that would guide us to that bias.

The next chart is nothing short of amazing to me, and I think you will be amazed at this fact as well.

As markets decline during a correction, it's normal for investor sentiment to become more bearish. When the majority becomes bearish, historically, the odds are that a market low is close at hand. This can be monitored with the American Association of Individual Investors Survey. At the website AAII.com, the Association polls their subscribership each week as to whether they are bullish, bearish, or neutral. The results are then published each Wednesday on AAII the home page. Let's see.

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The above chart displays a four-week moving average of those investors that are bullish divided by those that are bullish plus those that are bearish; a bull ratio. The historical data for this, many other market internals, indices, and currencies is available at PinnacleData.com. As I said, it's normal for investors to become overly bearish during a market decline, but they are too bearish now! This is amazing to see after the markets have been advancing and making all-time highs.

What will it take for them to believe in the uptrend and become too bullish? Higher prices, of course!

The markets have been moving up since the 2009 low and while it would be normal to think this bull market could be near an end, fight those bearish feelings. Human nature and common sense is not a good guide in the markets. For that reason, we need objective tools like those shown to guide us.

The bull market will continue until the majorities believe in it and are jumping in. If you've been afraid that it's too late to learn about the markets and participate, the above charts tell us that is not the case at all.

By Greg Capra, President & CEO, Pristine Capital Holdings, Inc.

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