By Brandon Matthews
Have you heard about the Fed and "The Ben Bernanke?" Apparently, people are beginning to understand that "The Quantitative Easing" also known as "QE2", or "The Printing Money", is less about job creation and stimulating the economy, as it is about the government lowering its borrowing costs as tax revenues to pay them, decline.
Economists are beginning to take notice, and some are already calling it a failed economic policy. Of course, it did not fail, because the government will pay less interest, which was the primary goal. Unfortunately, the expectations of QE2 giving a boost to the economy by creating jobs and boosting confidence, will disappoint once again.
The Department of Homeland Security issues various alerts based on threat levels. Similarly, The Department of Defense uses its DEFCON (Defense Condition) alert system. For the stock market, the closest thing I've found to an early warning system, is The New York Stock Exchange Bullish Percent (NYSE.BP) indicator. Tom Dorsey of DorseyWright.com wrote in his book that if he had only one chart to rely on, it would be the NYSE BP chart.
Until recently, this chart correctly predicted every major market correction in history. Government manipulation of the markets over the past few years, has caused this particular chart to issue some false positives. Still, it remains my most reliable risk management tool. The chart is now placing us on "high alert" status. In military terms, we are at DEFCON 2.
The rule is that when the NYSE bullish percent rises above 70% and reverses to under 70%, a market correction is likely. While many consider a ten percent market correction to be little more than an annoyance, it is misleading. Depending on the correction of individual sectors, losses of up to 90% can occur in one, while another sector may correct very little, resulting in an average correction, reported as 10 to 20%. As the charts below demonstrate, the current risk / reward scenario offers very little in the way of upside potential as opposed to downside risk.
The chart has topped at least temporarily at 76%, and currently stands at 73.709%. Let's look at this chart from a very basic perspective. Ignoring most of the chart and with absolutely no need to understand any of it, the green arrow represents the current upside potential, while the red arrow represents the current downside risk.
click to enlarge
Now let's look at this from a historical perspective. Going back to 1994, I have isolated each occurence of the NYSE BP rising above 70%, shown highlighted in green. As the bullish percent suggests, during these times equities were on a roll and people were buying. They were buying so much in fact, that 70% or more of NYSE listed stocks were indicating buy signals. Yet, as you can see by the red highlights, sentiment quickly turned against the bulls. Take note of the green tips and it is clear that upside potential here is extremely limited. The black arrow is where we are today.
Stocks tend to take the stairs up, and the elevator down. One of the reasons for this is that from a short sale persective, there is less risk involved with shorting stocks at these levels, and greater downside potential (a positive for short sellers). This does not mean that the market is going to crash tomorrow, although it could. It may remain at these levels for quite some time, and there are always opportunities in the market when selecting individual stocks. Investors need to take responsibility for their own protection during these periods of high alert.
Some ideas to protect assets including selling out completely, but at the risk of losing further gains if the correction does not occur quickly. PUT options as insurance are a good way to remain long equities while protecting against a sudden market meltdown. There are also a host of short ETFs and funds which will gain substantially in the event of a correction, such as the ProShares UltraShort S&P500 ETF (NYSE:SDS). Existing gains can be reallocated towards these types of funds, allowing investors to have equity exposure while minimizing the impact of a correction on a portfolio.
With the NYSE BP above 70%, it is not a question of "if" a correction will occur. From a historical perspective, it is inevitable. The only question, is "when?"
Disclosure: No positions at time of writing this, may be buying SDS or another short ETF this week.