It may seem like the height of folly to be talking about an upturn in the market on a day when the DJIA is down 230 points, but I’m not going to let that stop me.
Apart from the recent bump in the markets, I see several factors that lead me to believe that the markets are poised to continue to go up from current levels. The first of these, as highlighted by J.J. McGrath on his MackTheKnife blog, is that money formerly on the sidelines is starting to flow back into mutual funds. It may not be a flood yet, but it is a toe in the water. The second factor is the persistent extreme readings in put to call ratios that are evident in the ISEE and the CBOE equity only numbers. These numbers indicate that while some institutional money is coming back into the market, many retail investors are still sitting on the sidelines or have a short bias.
A third way to think about pent-up demand is to look at the McClellan Summation Index, a chart of which I have appended below. As can be seen in the chart, the index just turned positive for the first time since late October. While this is by no means a guarantee that the markets are moving up, this signal has historically been a bullish one. Perhaps more importantly, one way to think about the size of the red areas under the zero line is that these represent bearish periods in which pent-up demand continued to accumulate under the surface, roughly proportionate to the duration and magnitude of the red spike.
To summarize my thinking here, two bullish signals are mutual funds moving cash into the market and advance decline data turning positive, suggesting that the tide has turned. At this stage, only options sentiment data needs to normalize to indicate that the retail investor is once again comfortable going long and helping to push the market out of the recent trading range.