Cibeles Capital Euphoria/Alarm reversal indicator

·        The Cibeles Capital Euphoria/Alarm Index tries to identify when the market is over enthusiastic/pessimistic regarding equity markets, in an effort to predict S&P500 returns. It is important to read this index just as an indicator of positioning and sentiment, rather than to try to understand the drivers of the returns that we are forecasting fundamentally.

·        The index was constructed by using weekly data from August 2006 through December 2010.

·        The model tries to forecast 6-month forward returns on the S&P500 Index by using different positioning, risk and sentiment indicators, such as: total outstanding shares in emerging markets, open interest in Nasdaq and S&P500, Bull/Bear surveys, VIX, Put/Call ratio, spread in AAA corporates securities and Investors’ Confidence. All the variables were lagged 6 months.

·        In the out-of-sample period that goes from January 2011 through February 20102, the index presents a 73.4% correlation with the 6-month forward S&P500 returns (Figure 1).

Figure 1

Figure 2

·        On a rolling basis, the correlation is pretty stable between 65% and 80%, and way above the statistical significant value. This proves in some way the robustness of the model. (Figure 3)

·        Furthermore, 72.58% of the time, the model correctly predicts the direction of the market. (this was calculated using the number of times that the forecast lies in the same direction as the actual return of the S&P500)

·        Finally, the index suggests that the six-month forward return of the S&P will be around 15%, with an average gain of 5.4% (figure 1). This could be translated into a bullish signal, given that the mean return over our sample period is around 1.5%. Moreover, if we look to the individual indicators, three of them are one standard deviation above their 6-month moving z-score (Open interest, put/call and SSIC), and one indicator is 2 standard deviations away (bull-bear). (figure 4). 

Figure 3

Figure 4

Appendix

AAA – USD domestic corporate AAA yield less US 5 years treasury

BULL_BEAR – Percentage of bullish investors over the next 6 months less the percentage of bearish investors

CMDTY – Weekly Bloomberg survey

EEMSO – Total outstanding shares of MSCI emerging market ETF

PUT_CALL – Put/Call ratio of equity options traded on CBOE

SSIC – State Street Investor Confidence

VIX – Volatility Index

OI – Aggregation of open interest on Nasdaq 100 and S&P500