The champagne corks were popping yesterday.

The S&P 500 rallied to a new recovery high. And it closed above its 200-day moving average (MA) line. 

The 200-day MA is widely seen as an important support/resistance level. When the S&P 500 is trading above the line, investment managers, newsletter writers, and financial television talking heads find it easier to promote a bullish stance. When the index is below its 200-day MA, the financial community spends most of its time wondering if/when the bear will attack again.

So, by closing above its 200-day MA yesterday, the market inspired confidence among the bullish community, which was quick to celebrate. Indeed, you couldn’t watch any of the financial news networks yesterday without hearing a parade of commentators speaking about how the bullish action was likely to continue.

The bulls were looking for a chance to party. And yesterday’s action gave them that chance.

But, every party should have a wet towel nearby to deal with unexpected messes. Please allow me to be your wet towel.

I think this seven-week-long rally is nearing its end. Yesterday’s action looked to me like an exhaustive move – where hesitant traders finally capitulated and bought stocks because they were so tired of missing out on the gains over the past few weeks.

Yes… the market can still push higher. Overbought conditions can get even more overbought. 

But, any extra gains the market makes in the short term are likely to be given back – quickly.

The Volatility Index (VIX) is back down to where it was at the market highs in November and December. It’s back down to where it was last week, just before the S&P dropped 50 points in two days.

The American Association of Individual Investors (AAII) reported last Thursday that the percentage of investors who think the market will be higher six months from now is up to 40%. The bearish reading is at 23%.

That’s one of the lowest “bearish” readings of the past year. From a contrarian perspective, it’s a giant caution sign. And, based on the action so far this week, I suspect the next survey results (to be reported Thursday) will show an even more extreme condition.

But, don’t let any of that spoil the party.

However, as your designated “wet towel,” please note the look of the following chart of the CBOE Put/Call ratio (CPC) – which has been one of the best market timing tools over the past year…

The CPC is a short-term, contrary indicator. It compares the action in call options to the action in put options. A reading above 1.20 shows extreme bearishness among speculators and can indicate a good time to buy stocks for the short term. A reading below 0.80 shows extreme bullishness and could indicate a good time to sell.

The CPC dipped below 0.80 in early December – right before the S&P 500 dropped 450 points in three weeks. The ratio dipped below 0.80 again in late December – after a blistering week-long rally that flipped investor sentiment from extremely bearish to extremely bullish.

The S&P 500 dropped a quick 50 points in just two days after that.

Near the end of January, the CPC once again dipped below 0.80. And, we got a fast 30-point decline in the S&P over the next two days. Granted… 30 points isn’t much of a move (just over 1% or so). But, for traders looking to make quick gains, a 1% move in two days is a pretty good payout.

Now, the CPC is back down below 0.80 again. At a minimum, the market is due for a pause right here. And the “worst case” could be a whole lot more damaging.

I recommended readers of my Delta Report newsletter buy put options on the S&P 500 near the end of the day yesterday, in part because of this indicator.

That trade may work out well, or it may not. But, based on the short-term accuracy of the put/call ratio in the recent past, I like the odds of this setup for a reversal to the downside.

Bullish traders were pouring champagne after the market closed yesterday. My advice, though, would be to put the champagne bottle down, put a cork in it, and see how things look next week.

Best regards and good trading,

Jeff Clark

Reader Mailbag

In today’s mailbag, a new subscriber comments on last Friday’s Market Minute…

I’m a fairly new subscriber, including Mastermind, and I just want to let you know that I’m really enjoying the sessions. In light of this article, just the knowledge of how to recognize the rubber bands on the stock charts has made the difference on the timing of entry and exit for a profit on my last couple of trades.

In the past, I’ve stayed in the trades too long and have given back or even lost gains. Now, it seems I’m able to turn the odds in my favor, which is never easy with the market and a novice trader. Thanks again.

– Richard

Were you celebrating after the markets closed yesterday? Why or why not?

And as always, send any other trading questions, stories, or suggestions to feedback@jeffclarktrader.com.