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If the last fifteen years in the stock market has taught investors anything, it is that managing risk is a vital part of the game. Given that (a) the bear markets of 2000-02 and 2008-09 both produced declines in excess of 50 percent and (b) a loss of 50 percent requires a gain of 100 percent in order to fully recover, investors learned that the "mathematics of loss" can be brutal.

In the rip-roaring days of the late 1990's, the game was about making as much money as possible. As such, risk management wasn't a concept on most investors' radar screens. However, the two brutal bear markets that occurred within the first nine years of the new century changed all that.

Investors Concerned About The Return "Of" Their Money

Nowadays, everyone is more concerned about the return "of their money" than the return "on their money." Sure, the gains from the bull markets are nice. But what folks really want today is to avoid getting smoked the next time the bears come around. And if ten investors were surveyed as to whether or not they think another next bear market is close at hand, at least seven will likely answer in the affirmative.

So, the question then becomes one of how do investors manage the risk in the stock market? Do they simply avoid the market altogether? Do they continue to play the buy-and-hope game? Do they diversify across asset classes, across time-frames, and methodologies? Do they try to hedge positions? Do they dollar-cost average in during declines? Or do they try and find indicators to get them out of market when risk rises?

Using Indicators To Identify High Risk Environments

Today's missive will address the last option: trying to find indicators that tell investors when it is time to take risk off the table. To be sure though, one of the most difficult things to find in the stock market game is an indicator that is consistently accurate. However, such indicators do indeed exist.

The first caveat to discuss is the fact that no indicator is perfect. Understand that no indicator gets every move right and that all indicators give false signals from time to time. In addition, investors should realize that an indicator doesn't always give signals that work in both directions (i.e. an indicator that provides a solid sell signal may not be produce good buy signals). And finally, it is important to recognize that every indicator ever dreamed up has an inherent flaw or two.

A Sentiment Indicator Worth Watching

Although market sentiment indicators are often misunderstood (remember, everyone can't be a contrarian!), there is one indicator that investors may want to follow consistently. In short, the indicator provides sell signals that tend to be long-term in nature and have been accurate 87 percent of the time.

The indicator utilizes the Investor's Intelligence sentiment data. Each week, the Investor's Intelligence survey indicates the percentage of respondents that are bullish, bearish, and expecting a correction.

In order to generate the indicator, one needs to take the ten-week average of the number of bulls divided by the sum of the bulls and bears.

Using The Indicator

Since 1970, when the 10-week average is above the 69 level, which indicates that respondents are overwhelmingly bullish, the DJIA has lost ground at an annualized rate of -1.0%. In short, when the indicator reaches that extremely bullish zone, it suggests that most of the market's buying power may have been exhausted. However, that's not the sell signal.

One of the best ways to use this indicator is to first wait until a bullish extreme is signaled (via readings over 69) and then reversed (via a drop in the indicator reading back below 67). This means that investors have first become extremely bullish over a long period of time and then the sentiment has reversed. It is the reversal that is key - and THIS is when the sell signal is given.

A Record of Strong Calls

Prior to Monday, October 7, this indicator has issued fifteen sell signals in the past forty-two years. Thirteen of those fifteen signals have been correct, meaning that the stock market declined subsequent to the signal being given.

The key to this indicator is a sell signal was flashed BEFORE (often well before) the big declines seen in 1974, 1977, 1984, 1987, 1998, 2008, and 2011. As such, when this indicator flashes a sell, it is a good idea to at least take note.

A Fresh Sell Signal

The reason this indicator is being reviewed this morning is it flashed a fresh sell signal on Monday with a reading of 66.9. Sure, it is a very close call, but it is a sell signal just the same. In essence, this means that investor sentiment has reached an extreme and is now reversing. And in the past, this has been an indication of trouble ahead.

Will the indicator be correct this time around? Has the mess in Washington artificially impacted the indicator's readings over the past month? Is this the time to sell everything and head for the hills?

Frankly, a healthy dose of hindsight is needed to answer the questions posed above with any degree of accuracy. However, this indicator appears to be suggesting that, at the very least, it is time to take some risk off the table and/or play the game more conservatively. And while using a single indicator in a vacuum is never a good idea, investors may be well served to at least be aware of what this indicator is saying.

Turning to this morning... Although there are other stories around the globe, the key focus in the market continues to be the happenings in Washington D.C. as politicians continue to dance around a potential debt default. Today, some optimism appears to be returning as Republicans may be willing to raise the debt ceiling in exchange for future negotiations on spending. The latest is that a new round of talks is scheduled today between President Obama and House Speaker Boehner. Stay tuned.

Positions in stocks mentioned: none

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