First, lets re-assess how we did with our last call, to see if we went wrong and if so to learn from our mistakes. Two weeks ago we used market breadth patterns to suggest a bottom was close and we would expect a rally. See here. In fact, we predicted back then, based on wave-analyses and Fibonacci extension available to our premium members*, “…we should see a low in the market this coming week, likely SPX2010-20, followed by a multi-day rally, likely to SPX2080-90 , before a much bigger drop will follow.”
4 days after our post, the market dropped to SPX2026; which is the 38.2% retrace of the prior SPX1891-2111 rally; as well as the 100% extension of the 1810->1947 rally, measured from the SPX1891 low: 1891 + (1947-1810) = 2026. Beautiful! After that low the market has now rallied -two weeks later!- to SPX2099 and chance. Quiet a good prediction in our humble opinion. Where we see the market top next is available to our premium members* only.
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Besides market breadth, we can also use other indicators to determine if a top (or bottom) is close or not. One of those, we found, and have used successfully (i.e. with a high success rate as no indicator is 100% perfect) is the equities only put/call ratio. We use it as a contrarian indicator. Namely, regarding tops we have found that readings below 0.55 and especially close to 0.50 means everybody and their neighbor are long the market with calls. Thus, that side of the trade has become very crowded and if everybody is long, expecting more upside, then there’s simple not much buying left to do. Instead only selling is left when everybody has bought.
The chart above (click to enlarge) shows the CPCE put/call ratio over the past 18 months**; excluding last Friday’s reading of 0.51. We observe 16 prior occasions with readings <0.55 of which 5 were at around 0.50. Of those 16 we find that in 10 occasions (red vertical dotted lines) the market put in a top that same day and retraced its entire prior advance. In 3 occasions we find the market topped a few trading sessions later (orange dotted lines) and in 3 occasions we find the market kept advancing (yellow dotted lines). Hence, and as said, the indicator is not perfect, but based on 18 months worth of data** the odds are 13:3 that a top is in or very close.
If we add to this the fact the VIX is at very low levels, see chart below (click to enlarge) and has re-entered I.I.s “top is close” zone ($14-$13, blue circles), we have additional evidence and reason to believe the market is closer to a top than to a bottom.
** for brevity we used a 18 months period, but have found these levels (0.55-0.50) to work over much longer time frames.