Monday, October 24, 2016

Current Market Action Still Seems To Show Greater Downside Risk Than Upside Potential Here

Over the past few market sessions I have back tested a number of different combinations of market conditions which are currently, and I am not seeing much in the way of forward bullish skews to the data.  Most everything I have ran which matched current market conditions were neutral or slightly bullish short term.  But there are a few studies which have shown consistent skews to the bearish side which are significant.  So my take away is that, stocks could break lower in coming weeks after this chop ends.

I don't have any insight into how the market will behave from now into the election time when considering the singular effect of the election.

One scan I looked at today is the following conditions:

  • total put/call ratio < 1.0 today
  • 5/63 day total p/c ratio less than 1.0
  • VIX high less than 13.5 today
  • VIX closes lower today
  • VIX/VXV ratio is < 0.85 today
  • SPY gapped up today
So basically we have a low VIX environment (which may be a contrarian signal, but not necessarily a timely one) where sentiment based on the put/call ratios has been toward the complacent side of average recently, and SPY is gapping up.

These occurrences can occur in clusters, and so I removed any redundant days after the initial day in a cluster, unless they were more than a week apart.  And the results were that all the time frames I compare from 3 days out to 2 months, showed a 2-3 times greater MAX loss versus MAX gain from the signal day (today).

Let me briefly say, that there are not many "random" scans that show such a lopsided skew to the downside in stocks.  Since stocks spend so much more time generally rising than declining, when we see these types of imbalances in forward returns to the downside, I typically take it as more significant that stocks are at risk of declining.  

Volatility rises when stocks decline, and so a significant price decline may occur rapidly in comparison to the steadier trending which may occur in an upside move of the same amount.  Part of my point here is that I have found it far less easy to find scannable market conditions which consistently demonstrate impending market declines.  What we more often see are windows with a skew to the downside, but with less precise ability to pinpoint "the top" in comparison to pinpoint a bottom where prices are likely to rebound.

And currently for the last roughly 3 weeks some scans have shown that looking out a couple months (or more) there is risk of downside.  So it may end up that most of the trade is choppy but then there is a week or so with a big price break where the losses really show up.

What I am choosing to do here is to get positioned in inverse ETFs with a time horizon of 2 months out as the "time expiration" on the trade.  From some other cyclical type analysis that I follow, it seems most likely that the downside would occur in November, or into December, assuming we do get a sell off of significance.


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