A Merry Christmas or a Lump of Coal?

All major sentiment surveys, the S&P dividend yield, the Shiller PE ratio, and cash levels at mutual funds are telling us the same thing; investors are the most optimistic they've been in years. In my experience the next long term move is never obvious to the investing public. When the herd get's bullish, I want to start thinking bearish (and vice versa).

Two of my favorite studies to look at are the put call ratio, and the McClellan oscillator/summation index are showing bearish conditions, similar to the May flash crash.

Chart 1: Put Call Ratio

 The put call ratio's 10 DMA has crossed over the 1 standard deviation line (the setup) and may have crossed back (the trigger). I say "may" because depending on the close over the next day or two, if they are extreme on the call side, it could temporarily drag the moving average back into the setup area. Regardless, the message is the same, speculators are betting heavily on the upside after the run has already taken places, and longs are not hedged and unconcerned with a decline.

Chart 2: McClellan Oscillator and Summation Index

Usually I like to sell the market when the 5 day moving average is much higher and turning back down through the 1 standard deviation line. However, a few times I have seen moves continue despite a rolling over McClellan, but when the market finally does change direction, especially when sentiment is peaking, the resulting move is generally fiercer than usual. Note in the above chart that not only is there a rolling divergence, much like the one that occurred right before the "Flash Crash" but this divergence is actually even larger and longer running. Not that this guarantees large downward move, but it is interesting to see this phenomenon again with the same reading on the put call ratio.

A new addition to the list of sentiment indicators reaching extremes is the VIX, which recently fell to 15. This confirms the put call ratio's signal and furthermore upgrades the significance and importance of the signal.

Chart 3: VIX

We can see from the chart here that the VIX is at extremes that it hits maybe only once or twice a year. The VIX is essentially what investors are willing to pay in terms of insurance on stocks. Clearly, investors are not worried, which is ironic because lulls in volatility precede spikes in volatility, in lay terms, the time to buy house insurance is BEFORE your house burns down, not after.