Last May, readers of my blog learned of the SKEW Index, and the subtle hint it was giving about the stock market.
I compared it with the better-known Volatility Index (VIX). You can read my comparison between the two here.
But that’s not important right now.
What’s important about the SKEW Index is that it looks at the volatility of out-of-the-money options. When traders expect the higher possibility of a “fat tail” event that can wreak some major havoc in the markets, they hedge by buying these options. As the volatility for these options increase, so does the SKEW Index.
When I first mentioned the index last May, it had rapidly risen from 120 to 131. For an index that trades between 100 and 150, this seemed like a huge warning signal. I suggested investors get defensive.
Events proved correct. Over the summer, stocks corrected with a vengeance, with a near-20 percent drop in the Dow. Markets became concerned with a Greek default for the third time. The United States lost its prestigious AAA credit rating. Economic data indicated a slowdown, possibly foreshadowing a recession.
Despite these problems, we’ve muddled through—and then some. Markets are at a post-financial crisis high. So-called “defensive” companies like name-brand blue chips, utilities, and health care companies, are at 52-week highs.
It’s tougher to find bargains in the stock market than there were six months ago. Yes, on an earnings basis, many companies are trading at cheaper levels than they were a year ago. But with so many major companies near their highs, caution is in order.
That’s where the SKEW comes in.
The SKEW fell in the second half of 2011 from 140 to 115. But since the start of the year, it has quickly risen to over 130. That’s the kind of fast increase that indicates that professional traders are wary of the market.
In other words, here we go again. The next few months could mark another temporary top in the stock market.
On the other hand, we could just have another relatively fast correction before stocks surge higher. As we’re in an election year, it’s certainly likely that some kind of government program or policy will come into play to keep the market juiced.
The SKEW doesn’t say anything about volatility, only that professional investors are worried about an unforeseeable event surging through markets. The VIX, which does measure volatility, is also slightly up since the start of the year. That’s no surprise. Market volume never came back from the lightly-traded holiday season.
At the end of the day, these two indices should only confirm common sense.
You make your money in investing when you buy, not when you sell. If you’re buying now, you’re paying the most for stocks since the start of the financial crisis.
A better investment strategy for the next few months may be to accumulate cash and put in some stop losses while waiting for better buying prices on the next pullback.
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