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Indicator: Risk of 'Black Swan' Event is Elevated

On February 14, I wrote about a ‘big fat’ buy signal (New Spin on Old Indicator Gives Big Fat Buy Signal).

Now this ‘big fat’ buy signal is met by an indicator that suggests elevated risk of a serious decline (‘Black Swan’ event).

Which indicator measures the odds of a ‘Black Swan’ event?

It’s the CBOE SKEW Index.

The SKEW Index is calculated by the CBOE. The CBOE is also responsible for the VIX (VXX).

According to CBOE, the SKEW is designed to measure the tail risk (= risk of outlier returns two or more standard deviations below the mean) of the S&P 500.

The SKEW Index basically estimates the probability of a large decline or ‘Black Swan’ event.

Similar to the CBOE VIX or VIX Volatility Index (Chicago Options: ^VIX), the price of the S&P 500 tail risk is calculated from the price of the S&P 500 out-of-the-money options.

The SKEW typically ranges from 115 to 135. Readings of 135+ suggest a 12% chance of a large decline (2 standard deviations). Readings of 115 or less suggest a 6% chance of a large decline.

The chart below shows the SKEW readings since January 2012 and plots them against the S&P 500 (IVV).

View enlarged S&P 500 / SKEW chart here

On Friday the SKEW jumped to 138.79. This isn’t the top tick (December/January saw 139.62 and 143.20), but it’s higher than 99.5% of all other readings since January 2012.

The red lines highlight that elevated SKEW readings (such as 138+) translate into limited up side potential and increased down side risk.

The SKEW is very helpful, but should be combined with other facets and forward-looking analysis.

The December 20, 2013 Profit Radar Report (Sentiment Picture) put the message of the SKEW in context with other indicators and forecasted the following:

“Bullish sentiment will catch up with stocks in January. This should cause a deeper, but also temporary correction.”

The S&P 500 and S&P 500 ETF (SPY) saw a ‘deeper but temporary’ correction and price and SKEW are basically back to where they were in January.

More up side is possible as long as the S&P 500 can stay above support, but the SKEW suggests that the up side is limited and any gains to be erased eventually.

How does the SKEW 'Black Swan' warning fit into the bigger picture outlook?

Here's a more detailed look at the S&P 500 long-term forecast: An Updated Look at the S&P 500 2014 Forecast

Simon Maierhofer is the publisher of the Profit Radar Report. The Profit Radar Report presents complex market analysis (S&P 500, Dow Jones, gold, silver, euro and bonds) in an easy format. Technical analysis, sentiment indicators, seasonal patterns and common sense are all wrapped up into two or more easy-to-read weekly updates. All Profit Radar Report recommendations resulted in a 59.51% net gain in 2013.

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