2 Charts That Show “Irrational Exuberance” In The Market

Traders are getting excited. And this has me a little nervous about the market.

The classic book on chart patterns, “Technical Analysis of Stock Trends,” was written by Robert Edwards and John Magee in 1948. After explaining the most common patterns, they wrote about the megaphone, or “broadening top.”

We can see this in a chart of the S&P 500. Blue lines in the chart below highlight a megaphone pattern.

This pattern “suggests a market lacking intelligent sponsorship and out of control – a situation usually, in which the ‘public’ is excitedly committed and which is being whipped around by wild rumors.”

Intelligent sponsorship is reflected in steadily rising prices with large buyers accumulating positions over time. An out-of-control market is one where prices are moving wildly higher, a situation Alan Greenspan would call “irrational exuberance” almost 50 years later.

We have our own modern version of “the excited public” that Edwards and Magee were worried about… the Robinhood investor. (I wrote about the platform, which caters to new small individual investors, and its effect on markets here and here.)

Lately, this group has been very active in the market. These investors aggressively bought in the market selloff and were famously buying shares of bankrupt companies despite the almost guaranteed loss.

What Options Activity Tells Us

Recently, we’ve also seen small investors turn to options and focus on calls, expecting ever-higher prices. This can be seen below in the put/call ratio. This indicator shows the percentage of puts bought relative to the number of calls that were bought. To smooth the data, I used a 20-day moving average.

Source: StockCharts.com

When the put/call ratio is 1, it means investors are buying the same number of calls and puts. When the number is above 1, people are buying more puts than calls; when it’s below 1, we’re seeing people buy more calls than puts.

In the long run, the average is about 0.7, which reflects this bullish bias in the markets. Recently, the average fell below 0.5 — a five-year low — indicating that traders are unusually bullish since they are buying twice as many calls as puts.

How I’m Trading

The fact that we’re seeing people buy twice as many calls as puts is a worrying sign. It means we’re in the type of market Edwards and Magee described where “the ‘public’ is excitedly committed and which is being whipped around by wild rumors.”

The megaphone and other data are screaming that we should be cautious in this market.

But I’m not sitting on the sidelines completely. In fact, I recently recommended a trade in Automatic Data Processing, Inc. (NASDAQ: ADP), a stock valued for income. In fact, this company has paid a dividend every year since 1989.

ADP provides cloud-based payroll and HR solutions. This is an industry with high barriers to entry. And while this is a $150 billion market, ADP’s market share, while significant, is just under 10%. That leaves ample room for growth, in the long run. In the short run, the company faces challenges associated with the global recession. Over the next 12 months, management expects revenue to drop by 3%-5%, and earnings per share (EPS) could drop by as much as 15%.

Not surprisingly, analysts’ estimates are mirroring management’s guidance. ADP has beaten expectations in 12 consecutive quarters, including the last two, which reflected challenges associated with the economic shutdowns. And despite the expected weakness in earnings, ADP’s dividend is well covered. If the market does decline, ADP could be among the strongest stocks in the bear market — just like it was in the 2008 bear market.

Action To Take

ADP is an attractive stock in a bear market. In fact, I recently recommended a short-term trade in the stock to decrease risk even further.

Either way, this is exactly the kind of thing you should be doing right now. There could be a real shift taking place in the markets right now, and the typical high-flyers may not be the leaders going forward.

Another route is to look for much smaller companies that can grow earnings at a high rate for years to come.

My colleague Jim Pearce recently told readers of his Radical Wealth Alliance trading service about a pick like this… And since then, this small company has gained 40% in less than four months. And he thinks it could go a lot higher.

Want to know more? He’s written a full report that identifies this company by name and explains why he believes it is about to make a massive move to the upside.

To access this free report, click here.