This email came to me today which crystalized my thinking about stock market-based sentiment as measured by the 2CS:
"Just found your blog last week and am curious about the recent action in the 2CS.
"I have the 2CS going to 88.9 on Tuesday, 7/21, but it has now begun moving back up and based on my calculation it is now, after the close of 7/24, up at 98.97.
"The 88 reading wasn't as low as the 70 reading you were looking for from your last blog entry so I'm wondering if this change is notable. Does this change in the 2CS just mean that the 2CS has changed direction and that one should not expect a change in market direction until the 2CS finally drops into the 70 or less area? Or does this change in the 2CS portend a change in market direction?
"And just what are the parameters for the 2CS?
"Thanks, x"
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My response:
This afternoon I am wondering the same thing. By the way, I have always used the VXO or old VIX of the SP100, so my numbers are a bit different from yours (93.4 on Tuesday and 100.9 today), but question remains as you have asked. What does it mean now?
Over the years since I started (1996) doing this 2CS measurement (5 day running totals of each day's final CBOE P/C ratio times each day's final CBOE VXO), I have noticed what I call "sentiment divergence" at some tops and bottoms. Normally we would expect sentiment to be most bullish at a top (lowest 2CS). But sometimes the lowest 2CS reading can come a few days to a few weeks ahead of the price top.
However, we also have another problem right now which you also mention, namely that it would be very unusual to have the lowest reading for a top with 2CS in the 90's after such a dynamic and time-consuming rally, even if it's a bear market rally.
I have been thinking about these two aspects of price and sentiment for weeks. The best answer I can give so far is that the stock rally either has quite a bit farther to go up in price and in time OR this is a very bearish sentiment divergence both short term (current short term divergence) and long term (deviation from normal market top 2CS levels. Either/or doesn't seem like a very useful conclusion, but I think it gives some help. At the very least it is saying that the risk/reward profile of the market may have changed for the worse. Normally I might not even say that since the short term divergence is only a few days, and that happens sometimes. But the deterioration of the 2CS during these few days occurred when the price of the SPX rose quite a bit.
Different people will have different responses to a change in risk/reward probabilities. I tend to start exiting positions slowly, bit by bit, as the market rises.
Anyway, I appreciate your interest and your understanding of the problem. Let me know your ideas, and feel free to post at the weblog site if you wish.
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