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Have we just found a New Leading Indicator?

|Includes: SPDR S&P 500 Trust ETF (SPY)

Article from Investophoria with permission from Author.



Here at Investophoria, we have been hard at work taming the bear and the bull. This is, indeed, the mission statement, the "slogan" by which we operate. It is our goal to keep ourselves and you, dearest readers, from being gored when short, maimed when long, or trampled by sideways erosion.

To keep the tradition alive, we are constantly sniffing out clues as to where the broad measure of sentiment is headed in relation to where it is today (every day).

Most of the headlines you read infer causality between events and market fluctuations. Or they infer inverse-causality (for example, today - "Stocks Mixed Along with Data" from our friends at TheStreet.com)


Funny enough, if you check back at about 4:15 you will see one of three things 

"Stocks flat along with mixed Economic Data", 

"Stocks up on [one piece of good data] - continuing claims were slightly less today than expected", 

or 

"Stocks down on [one piece of bad data] - the trade deficit was about 20% higher than expected."


Seriously.  I challenge you.  Head on over to TheStreet.com and see what their market wrap up headline says about the day's trading. Or any other news-wire finance/economic daily publication.   After much study on this inferred correlation that media tries to use, I have realized that they miss the point entirely.  That being said, saying "Markets drop as Trade Deficit balloons" sounds a lot better than "Markets drop as the only explanation is a lower sentiment toward price level by all participants today than yesterday".  And these folks have papers to sell!  (or web hits or video views or commercial air time)


But that doesn't exactly jump off the page.

So... how do you measure sentiment?  Well, there are readings like the D.S.I (Daily Sentiment Index), which is a broad poll of traders and market participants.  It's pretty good for determining turning points in markets.  Okay, what else.


Oscillators are a good tool - you MACD and slow/fast Stochastics, etc.  RSI is a good indicator of sentiment.  But these are all indicators that tell you when you are at an extreme level low.  However, I might have just found a sort of leading indicator that I'm going to be looking into a little more deeply.


Call it a roving case study in data-we-have-used-before-for-confirmation-but-not-for-anything-else.  Might end up being an interesting find.  What do you think?




 
It would appear that we might have stumbled upon something at first look.  Of course, you can't just do ONE experiment and say you've got a proven hypothesis.  We'll keep you posted on this one.
 
It makes sense though, when taken within the context of a market acting as a market.  Since price is driven by perception first and follow-through action second, it would make sense that perception could go to new extremes while action peters out.  This is a good indication of a coming reversal of the trend in price-perception.
 
The Money Flow Index  (MFI from here on out) is actually a very strong indicator in general.  Unlike many indicators of its ilk, it is volume weighted, which gives a much clearer picture of the extremes.  Notice that before the all-time top in 2007 - long before - the MFI had already started to fizzle downward.  After the major crash, it bottomed all the way back in October, but the lowest lows weren't put in until March 9.
 
On that note, it is very possible we are seeing a similar sort of turning point coming up based on this indicator.  MFI topped out in early June.  Based on its action compared with actual price movement there is a good chance we will see one final rally on a weaker MFI, possibly pushing the markets to new highs, followed by a true trend reversal and the continuation of the bear market trend.

As always, these markets are tough to trade and I recommend safety over risk hands-down right now.  Risk appetite is revved up across all sectors of the market right now (they are selling securitized life-insurance buyouts now!), meaning speculators are rampant. 

Speculation in and of itself is not bad but higher levels of it indicate extremes in sentiment and price movements are near at hand.
 
Be careful out there guys.  And as always, happy trading!
 
Derek.

Disclosure:  I do not have any open positions on the S&P 500 Futures markes.  I do have short positions in several financial companies and long-term puts as of late August/early September.