Not all Indicators Are Created Equal

 | Jan 24, 2012 | 3:30 PM EST  | Comments
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There are a billion indicators out there. I tend to rely on relatively few. Over the years, I have found -- like with most things -- less is more. In the past 25 years, when I have tried to follow all of the arcane indicators available and all the fancy algorithms, I have found that it simply results in a lot of conflicting information that I ultimately have to filter out. So, when the dust settles, I'm back to using my old favorites, such as seasonality, sentiment indicators and overbought/ oversold readings of the simplest degree and, of course, gaps. That's what I always rely on. All the brilliant hedge fund guys with all their fancy technical indicators, generally lost money last year. So what's the big deal?

Yesterday, I heard from an astute subscribers about someone who bought a billion puts on the Market Volatility Index (VIX) as it was trading at multi-month lows. This story was getting tweeted all over the place. I asked my subscriber, "What is someone supposed to do with that information? Buy or sell?" That, after all, is the problem with so much information. What do you do with it? So someone buys puts on the VIX as it hovers near multi-month lows thinking that, because it has been dropping (as it always does when the market rallies), it will continue to drop because the market will continue to rally. Quite a call on the market after one of the sharpest advances of the past 12 months. Quite a call just hours before the Dow Jones Industrial Average dropped 150 points from yesterday's highs to this morning's lows. And, of course, all those VIX puts that the big, deep-pockets trader bought yesterday just got much cheaper. So what was so smart about that trade? Nothing.

The point is, when some big player makes a big directional bet on the market, he has about a 50-50 shot at being right. That's how useful the information is that some guy bought a billion puts on the VIX. It's about as useful as knowing that half the sports analysts and gamblers in the U.S. thought that the San Francisco 49ers would win Sunday's game against the New York Giants. That and about $3 will buy you a cup of coffee at Starbucks. That's all it will get you. Nothing more. Same story with the VIX futures. Some folks seem to think that traders of the VIX futures know something special. They don't. They know what you know and what I know. That's all.

So, if they bid up the VIX futures premium on a given day, so what? They are just telling you that they think the market might be setting up for a tumble. They might be right, but probably aren't. Don't get me wrong. The VIX is certainly a useful indicator because, to some degree, at least on a relative basis, it measures the amount of fear or complacency in the market. That is a solid contrary indicator (or at least it used to be). But making a big fuss about what some big buyer of VIX puts is doing on a given day or what the VIX futures traders happen to be doing or thinking has no bearing on what the market will do in the near term, is ultimately just an exercise in futility, and at best is just a waste of time.

Speaking of the VIX, it gapped up this morning from yesterday's close at the 18.67 level. That might be relevant as that gap will probably get filled in the days ahead. More important, however, is the fact that the VIX traded at new multi-month lows last Friday. That's not bullish any way you slice it.

VIX - Still a Valuable Indicator
Source: optionsXpress

For the very short term, the most compelling story of the day is to be found in the chart pattern of the E-Mini S&P 500 Futures. Here, as discussed in Friday's column, was a little gap left from last Thursday's opening at the 1302.25 level. As I explained in Friday's column, that gap represented short-term support and "might represent a short term spot to buy..." On Friday, I said that I would probably skip it in deference to the market's overbought condition, but this morning, as the futures pulled back to that level, I bought SPDR S&P 500 (SPY) calls at least for those option accounts where I had some bearish exposure. That enabled me to at least neutralize my short call premium. The low this morning was 1301.50, less than a point below the bottom of that gap. From there it's been back up toward the opening gap, almost tagging it at 1311.00, but, so far, making a high of 1309.75, leaving the opening gap partially intact (1309.75 to 1311.00) and providing a short-term target for the next bounce, aka resistance.

E-Mini Futures - Bouncing off of last Thursday's gap
Source: RJ O Brien Futures

In Friday's column, I also pointed to the gap in the SPX from Thursday at the 1308 level as possibly marking a spot to buy for a bounce. This morning's low of 1306.06 was less than 2 points below the gap and from there the SPX has rebounded almost back to unchanged at the 1316 level, but not quite, still leaving the opening gap at 1316.00 intact.

SPX - This morning's gap at 1316 is first overhead objective
Source: optionsXpress

As for the market's overbought condition, last Thursday, the McClellan Oscillator scored a fully overbought +171.5, which was the most overbought it has been since the +237 reading of Oct. 28. In case you've forgotten, Oct. 28 marked a multi-month closing high. From there, the SPX sold off 127 points, or about 10%, into the Nov. 25 lows, just about a month later.

Given the market's overbought condition, I can't get too excited about the long side here, but I am willing to nibble at the long side on dips to support. This morning's pullback to fill last Thursday's gap was one such dip, and I did a little buying as that gap was filled. If the market backs off again to lower levels, and completely works off its overbought condition, I will add further to my positions. For now, I'm content to hold up to 40% invested overall, including long junk bonds, short treasuries and long precious metals funds.

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