These 2 Charts Tell Us How Much Speculation Is Going On…

As all of you know, I follow dozens of charts on a regular basis. Most weeks, I share a few that are interesting for one reason or another. Sometimes they’re important indicators of what’s going on in the economy, and sometimes they’re simply things that have caught my eye.

This week, I have a few doozies to share.

The first chart is one I’ve been watching over the past few weeks with total disbelief.

It’s a chart of the iShares Micro-Cap ETF (NYSE: IWC).

If you break up the U.S. equity market based just on market caps, micro-cap stocks make up less than 3% of the entire thing. IWC includes the smallest 1,000 securities in the small-cap Russell 2000 Index, plus the next 1,000 smallest eligible securities by market cap.

The largest stock in the index has a market cap of about $7 billion. The median value is about $1 billion. For comparison, the median stock in the S&P 500 has a market cap of $20 billion.

Recently, small stocks have become popular among individual investors looking to turn small amounts of capital into big wins. This surge in popularity has pushed IWC to unprecedented extremes. The green indicator at the bottom of the chart shows that the ETF is more than 40% above its 200-day moving average (MA).

Generally, an ETF will trade within 10% of its 200-day MA the majority of the time. And when we do see a move to the extremes, it’s often followed by a sharp reversal.

And this extreme action isn’t exclusive to IWC…

While that ETF includes some of the smallest stocks in the market, there are still some stocks out there that are even smaller. These teeny, tiny stocks are often called “penny stocks,” and they are also booming. Volume in these stocks is up about 2,000% in the past year.

Source: The New York Times

The New York Times reported:

“It’s part of a “massive surge” in retail trading reminiscent of the 1920s, when amateurs flooded into the stock market before the 1929 crash, said Tyler Gellasch, a former Securities and Exchange Commission official who leads the nonprofit Healthy Markets Association.

“The only relevant historical precedent seems to increasingly be the days before the Great Depression.”

What This Means…

Speculative excess like we’re seeing in micro caps and penny stocks is often a sign that we’re near a top in the market. But it’s only a sign.

Stocks can continue higher long after the signs start to appear. For example, consider that many of the small investors out there chasing penny stocks are about to receive stimulus checks for $1,400. A number of those investors may use that money to buy more micro-cap stocks, putting that money back to work in the stock market. This will boost profits of market makers and other Wall Street firms who will then put their profits to work in other parts of the market.

Doesn’t sound like a recipe for a dip, does it?

My Income Trader Volatility (ITV) indicator confirms that the upward move we’ve been seeing could continue. ITV is similar to VIX in that it rises as prices fall. At the close last week, the red ITV line for the SPDR S&P 500 ETF (NYSE: SPY) was near its moving average (blue line in the bottom panel of the chart). If the S&P 500 was about to drop, we’d expect to see ITV moving above its moving average.

While the price action looks toppy, ITV’s bullishness tells me we could move higher.

That’s confirmed by my Profit Amplifier Momentum (PAM), which is also bullish. PAM (bottom panel) is shown on the daily chart of SPY below.

PAM is designed as a short-term momentum indicator that is specifically designed to minimize the risk of whipsaw trades.

Action To Take

Looking at the excess speculation in the market makes me nervous… but my indicators tell me to be bullish…

The answer? I’ll invest with both ideas in mind, remaining conservative and ready to take profits quickly.

That’s why I’ve been telling readers about my trading strategy that works a lot like “insurance”…

The great thing about this, though, is that we get to not only protect ourselves — but also profit by writing our own “protection policy”. It’s the best of both worlds… The immediate “premiums” we receive are a nice way to earn extra income, but it also protects us against potential downside in the market.

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