I'd Tread Carefully Here

 | Dec 10, 2012 | 9:30 AM EST
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As an avid follower of volume, I look for trends to help define direction. In general, it's bullish when stocks are trading higher on strong volume, while a pullback on higher volume tends to be bearish. The same dynamics are set for a climb on weak volume (generally bearish) and down on weak volume (bullish). While a solitary data point can be useful, a trend is established or dictated by multiple occurrences, on the whole.

With that in mind, recently the down days has seen higher volume, even against the selling we've seen repeatedly since late January. You can cite any reason you wish -- Middle East unrest, inflation, fiscal cliff or taxes. They are only reasons and excuses. After all, the market has really been on a non-stop tear since early June. Who could blame anyone for taking some profits off the table? Still, the last few weeks have shown a nice, robust rally off the Nov. 7 lows -- though this has been on very low volume.

Should we be concerned? Ryan Detrick from Schaeffer's Research tells us not to worry about it -- he believes a different dynamic is at work.

I would have assumed that solid buying should follow up some big-time selling -- that stocks are in the hands of strong holders. That hasn't been the case, and here we are in December. Is this critical? Earnings season is only a month away, so certainly we'd like to see some conviction, but it's just not there. Perhaps when some of the political issues are settled, we'll see some good buying come back in, but for now listen and pay attention to the market -- which is telling you to stay cautious when the buyers are not active.

VIX -- Daily
Source: StockCharts.com

There are a few solid sentiment indicators that show me where markets may be headed. Chief among them is the CBOE Volatility Index (VIX) -- and, as we see from the chart below, the crowd is showing complacency relative to historical standards. Should that worry us? We have seen the fear of a big drop mostly removed, thanks to actions from the Federal Reserve, the European Central Bank and others. Buying when the VIX is slumping usually isn't a good move, especially when the indicator is in a tight range. I have advocated picking up protection here, as it is relatively cheap at the moment. Few are interesting in buying puts these days to protect their positions, but it's never a bad idea to buy some insurance.

Put-Call Ratio -- Daily
Source: StockCharts.com

The put-call ratio is another great tool that can signals shifts in sentiment. The chart below -- the equity-only put-call -- shows consistently low readings, meaning puts are not actively being played. This is same message as that conveyed by the VIX. What to do? As a trend trader, I'll go with it until it's not working, but these volume and sentiment signs should have us all on alert for a quick change in emotions.

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