Stocks meandered through an up-and-down trading range during July, which ended with a bearish thud last week.
The Dow Jones Industrial Average erased all of its gains year-to-date, with a decline of 2.6 percent last week. The S&P 500 Index, Nasdaq and Russell 2000 Index also fell more than 2 percent, as the U.S. stock market closed out the month in the red.
It was the first monthly decline since January and has investors wondering if this is just the start of a long-overdue 10 percent-plus correction for stocks.
Aside from rising geopolitical risk from several hot-spots around the globe, investors are also concerned that an improving U.S. economy may force the Federal Reserve to raise interest rates sooner rather than later. Amid signs of accelerating inflation pressures, uncertainty about the timing of Fed policy triggered a spike in volatility as shown by the Chicago Board Options Exchange Volatility Index (VIX) below.
VIX surged more than 30 percent higher last week alone to the highest level since April. The S&P 500 posted daily gains or losses of more than 1 percent three times in the past two weeks, compared with zero one-percent moves during the previous two months!
So is this just another mid-summer market squall — a short, sharp correction that may soon give way to new stock market highs — or is a steeper correction ahead? To help answer that question, here are a few key indicators of market sentiment you should be watching closely.
Indicator #1: First, keep a watchful eye on the price action of VIX itself. Also known as the market’s fear gauge, VIX does a good job of marking short-term peaks in bearish sentiment, which often correspond with bottoms in the market. VIX is a very … well … volatile index. You can see in the upper panel of the chart above that VIX is prone to quick pops higher followed by sharp drops.
That’s because fearful investors rush into options seeking protection amid uncertainty, driving premiums sharply higher, but that kind of panic move isn’t sustainable. When VIX spikes above 15 or 20, then declines sharply — losing one-third or more of its value in just a few days — this often marks a low for the S&P 500 Index.
Indicator #2: Second, while we’re talking volatility, another relationship to monitor is the tale of two VIX.
Many investors follow the VIX Index without being aware of its “twin” indicator, the CBOE Short-Term Volatility Index (VXST). As the name implies, VXST measures option premiums over a shorter time frame.
When VXST (red line in chart above) travels above VIX (yellow line), it’s a big red-flag that tells you fear, boarding on panic, is on the rise. But once the weekly trend in VXST turns down, crossing back below VIX and remains there, it often tells you investor fear has peaked and stocks have bottomed.
Indicator #3: Third, the McClellan Oscillator is an indicator widely reported in the financial media and included in most charting software. It measures the number of advancing versus declining stocks on the NYSE by calculating the difference between two moving averages (a 19-day average, minus a 39-day average).
The McClellan Oscillator not only works as an overbought/oversold market indicator, but it can also be a powerful signal of short-term trend changes when crossing the zero line.
When this indicator reaches an extreme high level (red dotted line) or an extreme low (green line), it tells you stocks are either overbought or oversold, respectively. As you can see, right now stocks are about as oversold as they have been anytime in the last few years.
Like VIX, the McClellan Oscillator is prone to making sharp spikes. Watch for a reversal of a spike low. When this oscillator reverses trend and begins making higher highs and higher lows, it’s a powerful signal that stocks have reached bottom.
Bottom line: No indicator works all the time at signaling the twists and turns of the stock market. But watching multiple indicators, each with a good track record for accuracy in the past, can provide valuable clues of key trend reversals in the stock market.