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Market Realist Chronicles: Protect your investments from a stock market bubble

Part 4
Market Realist Chronicles: Protect your investments from a stock market bubble (Part 4 of 5)

1 key metric to gauge investor skepticism about the stock rally

A metric to help you predict investor behavior

What you need is a metric to predict the likelihood of investors spooking. The short interest ratio gives you this key information.

The short interest ratio tells you how many shares investors have sold short versus the average daily volume. This shows you how many investors are betting the market will fall. In other words, the short interest ratio tells you how many days it would take for an investor betting against the market to get out of their position.

Short Interest on S&P500 ETF (<a href='/quote-page/spy/'>SPY</a>) 2014-07-09Enlarge Graph

The short interest ratio is currently at a ten-year high. The last time the ratio went past the current 3.7x was in January of 2004. This indicator doesn’t guarantee that the market will fall. But it’s a good measure of how many investors in your camp believe this rally isn’t sustainable.

III. The third step of my framework is putting it all together to decide how to react

How should you react?

So what should you do? Your gut feeling tells you the market is too optimistic. The futures market points toward a decline. And the short interest ratio is shouting “fire!”

So far, you know two key things:

  1. The economy is very fragile
  2. Investors are getting skeptical about the market

Now you need to understand what the downside is and what your alternatives are.

Chances are that the market will soon at least take a breather and dip back down. It’s important to understand that earnings season is just getting started. So you can expect some market volatility ahead.

You can’t know for sure if earnings will be positive. But the market does seem to expect more than a modest increase in earnings. The high short interest ratio might tell you that any disappointment at this point could burst the bubble and bring investors back to reality.

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