A reversal in uncertainty triggers a buy signal for stocks

Key points:

• The SPY liquidity premium cycled from the top of its 4-month range to the lower half
• After similar reversals, the S&P 500 displayed excellent returns and win rates over all horizons
• Signals that occurred in an uptrend were higher 85% of the time over the subsequent month

The SPY liquidity premium reverses from a period of uncertainty

After bottoming in late July as the S&P 500 peaked, the SPY liquidity premium, an indicator that gauges uncertainty, soared to the highest level in 19 months as traders flocked to the relative safety of the world's most benchmarked index before the traditionally sluggish months of September and October. However, the indecision has now eased, triggering a buy signal for stocks.

The model I use for the SPY liquidity premium indicator is similar to several other systems I've shared. I apply a range rank to the liquidity premium indicator. In this case, the optimal lookback period for the range is four months. The buy signal occurs when the range rank cycles from 100% to less than 42% and market momentum is positive.

The previous alert was triggered in March, leading to a 10% gain in the S&P 500 over the subsequent three months.

By applying a range rank to the liquidity premium indicator and optimizing the most effective lookback period and threshold levels, the model can identify when sentiment amongst traders has eased from a period of uncertainty.

Similar liquidity premium reversals led to excellent returns

When the range rank for the SPY liquidity premium cycles from 100% to less than 42% and market momentum is positive, S&P 500 returns, win rates, and z-scores are excellent. Although the system predominantly generated signals in bull markets, it effectively capitalized on mean reversion opportunities during significant drawdown periods like 2000-02, 2007-08, and 2022.

Signals that occurred in an uptrend for context similar to now

Suppose I include a condition that requires the SPY ETF to trade above its 200-day average when a reversal signal triggers. In that case, uptrend precedents show slightly better win rates with returns about the same as signals in any environment.

Sentimentrader maintains a liquidity premium indicator for the Nasdaq 100 ETF (QQQ). The same model triggered a buy signal on 2023-09-05 when the range rank cycled from 100% to less than 27%.

What the research tells us...

The SPY liquidity premium, a measure of uncertainty, rose to the highest level over the last four months and reversed lower, triggering a buy signal for stocks. Following comparable sentiment-based shifts, the S&P 500 consistently exhibited a strong tendency to rally across short-, medium-, and long-term time horizons. This propensity shows an even stronger outlook when the S&P 500 exceeds its 200-day average.