The most significant element going into the June low was positioning. Investors were hyper-aggressive buying hedges for equity exposure. Nothing has changed, especially after last Friday’s drop, and investors are still looking quite defensive. This is a positive in so far as it is indicative of investors that are fearful of the downside and possibly offsides. It creates a lot of fuel for advances that can demonstrate some momentum.
Let’s start with Sentiment Trader’s Major Combined Hedger Position. Traders are long $125 billion of bearish contracts that protect the downside. This value is down a couple billion in the last few weeks, but the current reading is the most extreme we’ve ever seen.
Construction per Sentiment Trader:
This is the combined dollar value of hedger positions in S&P 500, Nasdaq 100, and Dow Industrials futures contracts.
Sentiment Trader’s Equity Hedging Index combines many financial products that can be used to hedge equity exposure. The current reading of .74 is only a couple points below the June low. In other words, investors are just as hedged now as they were going into the June low. This is bullish.
Construction per Sentiment Trader:
There are many ways in which an investor or speculator can hedge against a stock market decline, among them:
- Raise cash
- Buy put options
- Buy an inverse exchange-traded fund
- Buy an inverse mutual fund
- Sell short a futures contract
- Buy credit default swaps
The Equity Hedging Index looks at each of those factors above and compares the current level to its historical average. The more each indicator shows hedging activity, the higher the Equity Hedging Index will be.
This is a contrary indicator, meaning that the higher the Equity Hedging Index is, the more likely stocks will rally going forward; the lower the Equity Hedging Index, the less likely stocks will rally.
The reasoning is the same as for most contrary indicators. When hedging activity is very high, it shows that investors are nervous about the market’s returns and have likely already sold (or, obviously, hedged). So further stock declines will not be as likely to prompt them to panic by dramatically lowering their ask prices and drive prices lower. This is evident when the Equity Hedging Index rises above 80, but in a roaring bull market the Index might only make it to 60 or 70.
At the other end of the spectrum, a very low (below 20) Equity Hedging Index shows that investors are supremely confident in a rising market, and feel little need to reduce their potential returns by hedging themselves against a decline that never seems to come. While that can pay off, it’s an aggressive stance, and markets tend to punish that kind of confidence. Therefore, an Index below 20 is a warning sign for stocks.
Next, we can look at the amount of option premiums paid. At a reading of 1.83, traders are spending $1.83 on put options for every $1 they spend on call options. The current level is higher than readings at the depths of the pandemic in 2020.
Construction per Sentiment Trader:
This is the ratio of total put premiums paid each week relative to total call premiums, so it’s a direct reflection of how much options traders are paying for one relative to the other. That makes it an effective measure of real-money, real-time, leveraged sentiment. When it rises to an extreme, it is a highly reliable gauge of option-trader panic.
Another method of hedging is to purchase inverse ETFs. Among major inverse ETFs (see description below), inverse ETF volume is 3.04% of NYSE volume.
Construction per Sentiment Trader:
There are a number of ways for investors to hedge their portfolios or speculate on a market downtrend. Options and futures have been around for decades, but are somewhat esoteric and outside the interest of most investors.
The proliferation of exchange-traded funds (ETFs) has changed that. Inverse ETFs, which profit when the market declines, have become extremely popular as a quick and simple way for anyone with a regular brokerage or retirement account to hedge against a downtrend.
For this indicator, we aggregate the volume activity in the most-established inverse ETFs. These have the longest history, with the most volume and assets under management. The funds are among the first ones that traders turn to when they’re expecting a stock market pullback and want to speculate on the downside or hedge their portfolios.
We take the total volume in these funds and express it as a ratio to total NYSE Composite volume.
This is a contrary indicator. When inverse ETF volume spikes to a high level, it means that traders and investors are scrambling for protection or to speculate on a decline. Usually, a bounce in stocks is soon to follow.
When investors lose interest in these funds, it typically means that stocks have been doing well and investors see little need to protect themselves. While it’s not as consistent a predictor, this too is a contrary indicator and suggests that stocks may be in for a rough patch.
All in all, there are numerous indicators that suggest a still elevated level of pessimism on stocks. The rally off the June low did little to burn off this bearish positioning. This is supportive of equites broadly and suggests the fuel for another thrust higher is in place.
*All charts and methodologies (in italics) from www.SentimenTrader.com.
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