The following is a reprint of the market commentary from the October edition of the Option Advisor, published on September 27. Prices and the chart are as of the close on September 27. For more information or to subscribe to the Option Advisor, click here.

"The crowd is right during the trends, but wrong at both ends"
~Humphrey Neill, The Art of Contrary Thinking

Analyzing investor sentiment, and more importantly drawing actionable conclusions from such an analysis, is a very tricky proposition. Humphrey Neill was a pioneer in this endeavor, and I mostly agree with his catchy phrase I quoted above. Neill is essentially saying that it is "normal" for there to be bullish sentiment during the "meat" of a market rally, but the ultimate market top will catch investors in way too bullish a position and the decline off the top will cause them severe pain. Similarly, bearish sentiment is to be expected on market declines, but investors will be way too bearish at the ultimate market bottom and will miss the ensuing rally.

But I think we'd all like to ask Mr. Neill how to discern the "trends" from the "ends." In fact, market tops and market bottoms are notoriously easy to spot with hindsight and difficult to determine in real time. And Neill would be the first to concede this difficulty.

The CBOE Volatility Index (VIX) measures the level of premiums in the options on the S&P 500 Index (SPX). When the level of option premiums spikes higher, it can be an indication of an extreme in investor fear as players scramble to buy put protection, a condition that usually occurs at or near market bottoms. When the VIX declines to the low end of its normal range, it can be an indication that investors may be excessively comfortable with the market, and thus the market may be at or near a top.

The accompanying VIX chart clearly shows the spikes in investor fear that occurred as we moved toward market bottoms in July 2006, March 2007, and August 2007 as shown on the SPX chart. But we had no way of knowing in real time whether these VIX spikes signified the "end" of the downtrend in the market or whether there was a "trend" of painful additional downside action ahead. There certainly were clues that these VIX spikes were terminal, not the least of which was that each of them occurred not in the context of a true bear market but rather in the context of pullbacks of 10% or less in a long-term bull market. And to the degree there is significant bearish sentiment within the context of a bull market this almost always has bullish contrarian implications.

Another clue that this summer's pullback was terminal was in the sheer magnitude of the VIX spike, which dwarfed those in 2006 and earlier in 2007. Yes, the markets correction was a bit deeper this summer, but one could easily argue that the spike in the VIX was way out proportion to the damage to the market. Of course, the frightening headlines and media stories made it quite easy to become very fearful about the market, but, alas, this is also what makes for market bottoms.

But let's see if there might be a more objective way of determining an "all clear" signal that could indicate to us that "the fever has passed" and that it is safe to assume the uptrend has resumed. With this in mind, the accompanying VIX chart includes a 32-week moving average, which I often use in my work as a trend indicator in place of the more traditional (and thus overly analyzed) 40-week moving average. Note the rally above the 32-week in May 2006 as the market began experiencing difficulties, and that the 32-week held as support in June and July 2006 as the market continued to struggle. But then the convincing break by the VIX below its 32-week in August 2006 was followed by an off to the races market rally. In other words, the market "fever" was signaled by the rise in the VIX above its 32-week moving average, and the "break" in this fever by the break below the 32-week. And at that point, it was "safe" to be long again.

The VIX "behaved itself" relative to its 32-week moving average (and the market correspondingly rallied) until February 2007 where the next spike above the 32-week is evident. What I find interesting is that throughout the recovery in the market in April through July, the VIX never broke back below its 32-week on a weekly closing basis. Was this indicating trouble ahead? With 20/20 hindsight, clearly so, as the market began tumbling in July and the VIX then soared to heights not seen since 2002.

And right at this moment as I type this commentary, the VIX is trading slightly below its 32-week. Should this be the case by Fridays close, it will mark the first such weekly close since February, and will be a strong confirmation that "the fever has broken" and that we are back in full bull market mode. I believe this will happen, if not this week then in the coming weeks, and that we will see new highs in the major averages before year-end. And I believe it won't be long before the bears begin to cite "investor complacency" as evidenced by a "low VIX" as a reason to be bearish, just as they were citing the recent high VIX levels as indicators of risk aversion and, you guessed it, a reason to be bearish.

Copyright Schaeffer's Investment Research http://www.schaeffersresearch.com

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