I am always looking for new information about the stock market. That means I spend a lot of time reading.
In this way, I think I’m a little like Isaac Newton.
Newton was undoubtedly one of the greatest minds in history. He identified the laws of gravity and created the field of physics, not to mention calculus, which he invented so he could more easily explain physics.
But Newton taught me something that’s, in my view, much more significant.
Newton’s greatest contribution is more fundamental: how much he emphasized studying the work of others.
Today’s TOM is going to be a bit different. I want to show you how I used this insight to develop one of my most useful trading tools.
And even more important, what it’s telling us about stock prices right now.
The Shoulders of Giants
Newton valued the work of others so much, he once wrote, “if I have seen further, it is by standing on the shoulders of Giants.”
I took that to heart. If I hope to see further, or even just as far as others, I need to stand on the shoulders of the giants who studied markets before me.
Among the giants in markets analysis is Larry Williams. My study of his work led to the creation of my volatility indicator that I’ve written about before.
Larry’s work also includes an indicator he calls WillVal, which defines when commodities are overvalued or undervalued.
The reason Larry invented this is because it’s impossible to apply standard stock valuation tools to markets like wheat or copper. There are no earnings or book value.
Some analysts create complex supply and demand models. But those models don’t really provide information like a price-to-earnings ratio does for stocks.
Williams looked at what the P/E ratio actually told him. Earnings provide a measuring stick for fundamentals. The P/E ratio shows where the stock price is on that stick.
WillVal also uses a measuring stick and shows where the market price is on the stick. The formula compares the price of the futures contract to a stable store of value like Treasury bonds or gold. Simple, but effective.
CNBC recently featured this indicator. The conclusion was that stocks are undervalued compared to bonds.
I really like this indicator, and so — standing on the shoulders of Williams — I looked at ways to build on it.
The Emotional Measuring Stick of the Markets
WillVal was originally designed for commodities. Bonds or gold make sense as the benchmark since they’re sensitive to inflation.
Stocks also react to inflation. But that’s not the primary driver of short-term market trends. I believe emotions drive stocks in the short run.
Based on that, I use the price of gasoline in the WillVal formula to measure the valuation of the stock market. This is shown in the next chart.
Well, for one, using gas as the measuring stick reduces the number of signals.
It also makes sense to me to use gas because we all get emotional about gas prices. Be honest. Your heart drops when you drive by gas stations and see the price spiraling toward $4.
And as long as we’re being honest, your heart also drops when you see the balance in your brokerage account spiraling downward.
The relationship between these emotions led me to my version of the indicator.
When the WillVal for gasoline (blue line) crosses above 25 after becoming oversold, we get a buy signal. That happened on Friday.
This indicator was out of the stock market for most of 2022. It’s saying buy now. The track record shows we see above average gains in the month after the signal.
This is a reason to be bullish, for the short run.
Senior Analyst, True Options Masters
Chart of the Day:
Failed VIX Buy Signal?
Today’s chart is of the CBOE Volatility Index (VIX), aka the market’s fear gauge.
In the past, I’ve shown you how to trade spikes in the VIX as broad stock market buy signals.
When the VIX closes above its upper Bollinger Band, and then closes back inside the bands, we get a broad stock market buy signal. You can see that at play in December and late January, as the VIX plummeted both times it came back inside the bands.
Strangely enough, the recent volatility hasn’t been enough to send the VIX outside its upper Bollinger Band. Though, it did come close.
Still, that means no buy signal for now. The VIX could remain elevated for a little while longer.
The level of the VIX hardly informs the chaos of the world and markets. But something tells me we’re going to see at least one more surge of volatility in the coming days that gives us our true buy signal.
Managing Editor, True Options Masters