The S&P 500 liquidity premium indicator triggered a risk-on signal

Key points:

• The S&P 500 Liquidity Premium indicator cycled from the upper end of its recent range to the lower half
• Similar shifts in this volume-based sentiment indicator produced excellent returns for the S&P 500
• The liquidity premium indicator can also be used to identify risk-off signals 

A sentiment gauge based on trading volume triggered a risk-on alert

The S&P 500 Liquidity Premium indicator compares the volume of the S&P 500 ETF (SPY) to the volume of the underlying stocks comprising the S&P 500. When volume in the ETF increases relative to stocks, the indicator rises, indicating that investors are uncertain about the outlook for the market, a scenario typically associated with corrective phases. Eventually, confidence returns and volume increases in individual stocks compared to the ETF, causing the indicator to shift lower.

A trading model that utilizes the S&P 500 Liquidity Premium triggered a new risk-on signal, the first since January 2024. Following that alert, the S&P 500 gained 7.9% over two months.

The system generates a buy signal whenever the 84-day range rank for the SPY Liquidity Premium indicator cycles from above 99% to under 42% and index momentum is positive. 

If you were curious, the QQQ Liquidity Premium indicator is trending toward a risk-on signal. 

Similar volume-based sentiment shifts preceded a bullish outlook

Whenever the SPY Liquidity Premium's 84-day range rank cycled from above 99% to less than 42%, with the index above its 200-day average and exhibiting positive momentum, the S&P 500 ETF (SPY) displayed excellent returns and consistency across all time frames. Furthermore, the signal exhibited significance relative to random returns in 6 out of 7 intervals.

Can we use the Liquidity Premium indicator to signal risk-off?

After the July to August 2024 correction, I analyzed the liquidity premium indicator to determine its effectiveness as a risk-off signal. My findings revealed that it can serve as an early warning for a potential market correction. 

The methodology mirrors the risk-on signal but with reversed parameters. A risk-off signal is triggered when the Liquidity Premium indicator's 84-day range rank transitions from below 1% to above 50%, accompanied by negative index price momentum. 

Following liquidity premium risk-off signals, the S&P 500 showed a fairly strong tendency to decline in the near term, falling 67% of the time over two weeks. At some point in the next month, the world's most benchmarked index displayed a loss in 28 out of 39 cases.

The average maximum loss exceeded the average maximum gain from one week to three months. Furthermore, over longer horizons of six and twelve months, the average maximum gain marginally surpassed the average maximum loss. 

The same system can be applied to the QQQ Liquidity Premium indicator. It triggers a risk-off signal when the 84-day range rank cycles from less than 1% to above 59% and index momentum is negative. Similar to the S&P 500 version, it's best used as a short-term signal. 

What the research tells us...

The S&P 500's Liquidity Premium indicator increased to an elevated level, indicating uncertainty or fear among investors. Subsequently, it reversed lower, triggering a risk on signal for stocks. Similar shifts in this volume-derived sentiment indicator produced outstanding returns and consistency for the S&P 500, especially when the index was in a long-term uptrend like now. The system for the liquidity premium indicator can be reversed to identify risk-off warnings. However, given the new risk-on signal, a warning will unlikely occur anytime soon.