Will confidence soon cost you?

Rick_PendergraftAlcoa (NYSE: AA) will kick off earnings season this week and the expectations have been on the rise. One report that I read has the profit growth of Standard & Poor’s companies, which make up the index for overall market health, hitting double-digit percentage gains for the first time in three years.

If you have read my articles before now, you know that I am a contrarian investor. Of all times that I find contrarian investing to be most important, it is around earnings. When a company is getting ready to announce earnings results, I highly recommend looking at the sentiment indicators very closely.

If there isn’t much short interest to speak of and if the analyst ratings are almost all “buy” ratings, this is a sign that almost everyone is bullish on the stock. If everyone is bullish and everyone that likes the stock already owns it, the only thing left will be sellers…

This same concept can be applied to the market as a whole. When expectations are extremely high on a stock, it becomes very difficult for the company to beat expectations, or at least beat expectations by a wide enough margin that people get excited and start buying.

While I don’t have the means to run a sentiment composite on all 500 stocks in the S&P 500, there are other measures for overall market sentiment. And those sentiment indicators are presently at multi-year high bullish readings.

The first indicator is the 21-day moving average on the CBOE Equity Put/Call ratio. This indicator measures the trading activity of both put and call options and it only looks at options on stocks and exchange traded funds, or ETFs, it doesn’t include index options. Because we are measuring puts to calls, a low reading is indicative of bullish sentiment and a high reading is indicative of bearish sentiment. By using a 21-day moving average we are able to see the trend in options trading and it offsets any abnormally low or high daily readings.

Now that I have explained the indicator, I can tell you that last Wednesday’s reading came in at 0.5019 and that is the second lowest reading over the past five years. The only reading that was lower was on December 30, 2010. What this tells us is that there are very few puts trading compared to calls from a historical viewpoint. Investors are more interested in the bullish calls as we head into the earnings season.

The second indicator that is reflecting extreme optimism is the CBOE Volatility Index (VIX). The VIX measures the implied volatility of S&P options over the front few months. Most investors view the VIX as a fear gauge. The higher the reading, the more fearful investors are at the time. Investors bid up the price of options, particularly puts, when they fear that the market is heading down. When the reading is low, investors aren’t very fearful and they don’t bother bidding up options—puts or calls.

Looking at a chart of the VIX over the last eight and a half years, we see that last week’s closing price of 10.32 is the lowest since February 2007. We also see that the VIX has been trending lower for the past two years in order to get to these historically low levels. Once again this suggests that investors are confident as the earnings season gets under way.

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While earnings have been improving since the recession in 2007-2009, the economy did have a hiccup during the first quarter of this year as we saw a contraction of 2.9%. I have to wonder if the slowdown will make its way into the second quarter earnings reports. Most analysts are predicting a much better second quarter for the U.S. GDP, but I have to believe it may have had an impact.

Despite the downturn in the GDP, investors have raised the bar for corporate earnings. When the bar is raised, it is much harder to clear the hurdle. The bar being raised gives me cause for concern this earnings season. Be careful!

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