July 23, 2019

We all need to stop and rest, but don’t tell that to Parisians. While New York is the city that never sleeps, Paris is the city that never stops. The city has one (and only one) stop sign – in the 16th Arrondissement. Throughout the rest of the city, drivers just yield to traffic on the left or follow the traffic lights.

But sometimes we need to heed a stop sign, especially in the stock market. For instance, it would be great to know when the market is about to overheat. Just like a car, we would be able to roll back the engine (our risk exposure) before it gets overheated, causing a meltdown (a correction).Luckily, the market has many stop signs. It’s just a question of whether or not we see them. The consequence of choosing not to see signs in the real world can be steep. The same can be said for ignoring the market’s warning signs.

One sign I rely on is the “overheat-meter” of big buying and selling. I look at more than 5,000 stocks daily. I then look for which ones likely have unusual buying and selling going on. Those buy and sell signals get tallied up and plotted on a ratio. You can see that in the Map-It ratio below.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

When the ratio goes into the green, the market is oversold. Historically, we can expect a market rally shortly thereafter. When it goes into the red, the market is overbought, and we can expect a pullback soon thereafter. You can see, below, that oversold conditions are very reliable. Overbought is a little less-so but still clearly something to pay heed to. Notice, the ratio is now in the overheated (orange) range.

When the orange light approached overbought (red) last week, that was a warning sign. It was an opportunity to take profits and reduce risk in some portfolios for aggressive traders. Notice what happened to the market and most sectors as soon as the market got overheated. We pulled back last week:

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The lone bright spot was Semiconductors, reflected in the signals. Information Technology saw some buy signals – 27 out of 180 possible stocks. Look at Materials, as well. The sector was one of two that were positive last week. And notice the buy signals (below), 22 out of 79. You can also see the power of big money trading in Energy. The sector was down -2.7% while 35% of Energy stocks logged sell signals.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The signs are there for the seeing; you just need to know what to look for. Imagine driving a car in a country that has completely different traffic signs and laws. You wouldn’t know what to look for. The market is similar. There are many different ways to navigate the market. Big money buying and selling is a way that I discovered through years of working on institutional trading desks.

Does an “Overheated” Market Imply a Coming Crash?

Now that we have our signals showing us an overheated market, what do we do with that information? Does an overheated market mean we are headed for disaster? The answer comes in the undercurrent…

Let’s look at the overall picture:

  • The market is overheated, not overbought. A retreat from being overheated back into neutral territory means markets can reset and resume an upward trend.
  • The overall trend has been big money buying.
  • The U.S. stock market remains the oasis in the choppy global landscape. Europe, Asia, and Latin American equities offer uncertainty at best. U.S. sales and earnings are continuing their strong march forward. As stocks rally, their dividend yields drop. But even with record high stocks, compressed U.S. bond yields are simply no match for investing in stocks.

Look at the table below and you’ll see that just buying the S&P 500 and earning its dividend yield of 1.87% gives you 18% more money in your pocket than buying treasuries at 2.05%:

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

An overheated market doesn’t mean get out; it just means be vigilant. I am using this opportunity to raise cash on profitable positions I don’t intend on being in for the long-haul. I am not touching core holdings or long-term positions. This is because history has shown that the market will likely just resume its march higher after any reset. To me, this means trim risk, raise some cash to have some cash on hand when the market offers us discounts on great stocks. So, when and if the ratio of buying to selling drops, I’d advise investors to have “dry powder” and their buy tickets ready. It means I am on the lookout for a potential buying opportunity in the coming weeks. August notoriously brings volatility. My data echoes this setup.

Markets ebb and flow. As I try to navigate them, I look to what the big money is doing. Right now, it’s telling me that buying is taking a pause. But that pause will bring opportunity. U.S. stocks are the best place to put money, but there may be bumps ahead as summer rolls on. Using the market’s signage can tell us when to speed up and when to slow down. But the most important thing is that we don’t panic.

U.S. stocks are still the best long-term place to be. As a $2 billion money manager told me: “Where else are you going to go? Do you want negative yields for the rest of your life?”

Maybe Paris sign makers read Confucius: “It does not matter how slowly you go as long as you do not stop.”

About The Author

Jason Bodner
MARKETMAIL EDITOR FOR SECTOR SPOTLIGHT

Jason Bodner writes Sector Spotlight in the weekly Marketmail publication and has authored several white papers for the company. He is also Co-Founder of Macro Analytics for Professionals which produces proprietary equity accumulation/distribution research for its clients. Previously, Mr. Bodner served as Director of European Equity Derivatives for Cantor Fitzgerald Europe in London, then moved to the role of Head of Equity Derivatives North America for the same company in New York. He also served as S.V.P. Equity Derivatives for Jefferies, LLC. He received a B.S. in business administration in 1996, with honors, from Skidmore College as a member of the Periclean Honors Society. All content of “Sector Spotlight” represents the opinion of Jason Bodner

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