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Why Present High Margin Debt is Worrisome for Stock Market. Although margin debt has declined a bit, this chart from Sentiment Trader indicates that it is still close to all-time highs. That’s despite many warning signs that the stock market is overbought. Why is this worrisome? Very high margin often precedes major market declines. It also means a lot of stock is in the hands of weak handed investors who are taking outsized risks that would subject them to market calls and outsized losses when the markets decline. In fact, high margin accelerates market declines. That’s because leveraged investors are forced to sell stock into down markets to meet margin calls. Note that margin spiked in March 2000 at the time of the dot.com crash. It also spiked before the financial crisis in 2007.
Short-Term Indicator is Warning Investors the Market is Even More Overbought. We thought it was important to show how The Investor Intelligence Short-Term Composite Indicator (see chart) has moved even further into overbought territory . As a result its showing close to 80% from slightly below 70% two weeks ago. At that time, we wrote about this important short-term market timing tool. A tool that has proven to be invaluable for sophisticated traders since it was developed in the 1960s. A reading of over 70 means the general index has become overbought.
Below 30, it has become oversold. In late December, as shown in the chart below, it was at a very oversold 4%. It showed a reading that proved to be very accurate considering the subsequent stock market bounce. The recent market bounce has rapidly moved the indicator to higher and higher overbought levels. The fast-moving pace of this indicator is another clear warning sign that the market continues to be highly volatile, and very risky. We recommend investors lighten their stock portfolios. We expect more and bigger downward corrections than the one that occurred in the fourth quarter before stocks reach oversold levels that would trigger a durable, longer-term rally.
History has shown us that retail investors as well as so-called market professional are usually wrong about the direction of the stock market. So betting against them is a way to help you make money. Strong evidence of that comes from the Investor Intelligence Bull/Bear poll of more than 100 stock market writers who historically are wrong about market direction because they are driven by emotion – very fearful at market bottoms and overly elated at market tops. For instance, in late December, just as the market was about to rebound, the Bull/Bear spread was – 4.7%, meaning bears out numbered bulls. That’s not an anomaly. Negative spreads traditionally have occurred before a rebound. The last time before December was in early 2016 when the spread was an even wider -14.5. That also proved to be a buying opportunity, as was November 2008 when the negative spread was -26.8% and at the index low in March 2009 when the spread was – 20.8%. Conversely, we use positive spreads (bulls outnumbering bears) of over 30% as elevated risk, while those above 40% call for defensive action.
Where are we now? The Bull/Bear spread has jumped from +16.9% a week ago to +24.1% In other words, now 45.4% of the professional market prognosticators are bullish and 21.3% bearish. That +24.1% spread is not a sell signal but is moving in that direction given the huge surge of optimism from – 4.7% in late December that in our view has been mindlessly triggered by the recent market rebound, and despite troubling economic warnings from Davos, as well as economic woes that could result from the longest U.S. government shutdown. Moreover, we expect more down moves. Stocks are historically too high. Typically bottoms are created with a series of corrections. The fourth quarter correction down move is only one of many more we expect before stocks reach oversold levels that would trigger a durable, long-term rally.
In other words, sentiment is a powerful contrarian tool to help investors make better decisions freeing them from the noise of experts who usually get it wrong.
The Investor Intelligence Short-Term Composite Indicator has proven to be a valuable tool for short-term market timing ever since it was developed in the 1960s. A reading of over 70 means the general index has become oversold. Below 30, it has become overbought. Three weeks ago, as shown in the chart below, it was at a very oversold 4, a reading that proved to be very accurate considering the subsequent stock market bounce. The recent market bounce has rapidly moved the indicator to overbought levels. This recent chart shows the indicator at 67.5 level, but it is probably above the oversold 70 reading after a subsequent market bounce. The fast-moving pace of this indicator is another clear warning sign that the market continues to be highly volatile, and very risky. We recommend investors lighten their stock portfolios. We expect more and bigger downward corrections than the one that occurred in the fourth quarter before stocks reach oversold levels that would trigger a durable, longer-term rally.
The chart below represents trading in the Financial Select Sector SPDR ETF (XLF) with a portfolio of the big-name banks and other financial institutions, a major stock sector for obvious reasons. Looking at the XLF chart over the last two years as a proxy for the financial stocks we can see that a very negative price pattern has developed. These stocks are being sold with very heavy volume and bouncing with very light volume. This is a dangerous trend because it shows that the large institutions are exiting this group. And using rallies to sell. Until the price action improves for the banking sector, I will find it hard to get bullish on the market over the longer term. Typically during times of major selloffs there will be periods when stocks become oversold, resulting in some bounce backs. While bear market bounces can be fast and furious, they also are typically short lived.