Record Puts To Calls Ratio Indicates An Important Moment

The Short Term – Master Sentiment Indicator

The short-term master sentiment indicator, shown in the chart above, is a composite made from seven, short-term sentiment indicators, which are listed in the next section. It’s based on the concept that any one sentiment indicator might not work well in a certain market but by forming a composite of indicators you get better results.

This indicator is intended to measure short-term changes in investor sentiment, looking for moments when there is a sudden jump in negative expectations. The idea is that these sudden changes signal a short to intermediate-term market low.

The scale on the left, which goes from plus 10 to minus 10, is the Sentiment King ranking scale and is fully explained in this article (here). The green area in the graph indicates extreme degrees of bearish sentiment while the red area represents shades of extreme bullish sentiment. It’s plotted against the S&P 500 SPDR ETF, (SPY) to show the ability of the ST-MSI to signal market lows.

The Components of the ST-MSI

The seven sentiment indicators that combine to make up the Short-Term Master Sentiment Indicator are listed here:

• Hulbert Rating Service (Stocks)
• Hulbert Rating Service (Nasdaq)
• VIX
• The 20% CBOE Equity P/C
• The 20% CBOE Total P/C
• ProShare Bull/Bear Purchase Ratio
• ProShare UltraPro Bull/Bear Purchase Ratio

This article focuses on the 20% CBOE equity P/C ratio.

The Puts to Calls Ratio

The puts to calls ratio, in its various forms, goes back to a Barron’s article published in 1971. It’s a contrary opinion indicator, which is fully explained in this prior article (Puts to Calls Article). This earlier article highlighted a longer-term version of the puts to calls ratio. The indicator discussed in the current article is a shorter-term version.

Our 20% CBOE Equity P/C is a time-weighted moving average of the daily puts to calls ratio of stocks; this method gives greater importance to more recent ratios than older ratios. This is what the 20% refers to in the description above. The most recent ratio gets full weighting in the total average. As a ratio moves a day into the past, it is given 20% less weighting than the previous day. While this procedure is approximately equivalent to a five-day moving average, we feel it’s slightly more accurate than a simple moving average.

These two charts show the short-term equity puts to calls ratio back to 2016. The top chart shows the actual ratio while the lower chart shows it plotted on the Sentiment King ranking scale.

The green circle on the top chart highlights the highest ratio in history of 1.14 registered last Thursday. This ratio means that over the last few days there were 114 puts bought for every 100 calls. It means that options traders have purchased more options expecting stock prices to decline than options expecting them to advance. Normally the ratio is around 60 puts for every 100 calls.

This ratio of 1.14 is higher than any time during the two-year financial crisis of 2007-08. As the chart shows, it’s higher than the peak level reached at the bottom of the 2020 pandemic crisis. What is particularly important to us is that this ratio is occurring not at a market low but at a price that’s 9% above the market low of two months ago. To us, this is highly significant.

Why? Because it is somewhat normal to see high levels of put buying as prices decline but it is not normal to see it with prices 9% off the lows. To us, it indicates widespread belief that the current rally is a bear market rally and investors are buying puts expecting prices to soon roll over and surge lower. If it does, they make great profits.

To Capitulate or Not To Capitulate

There is the widely held belief that all major price declines and bear markets end in capitulation. This is not true, however, and holding to it 100% has caused many investors to miss a number of major buying opportunities. The truth is that all major lows occur when the vast majority of investors expect further price declines. Sometimes these moments occur with “price capitulation”, sometimes they don’t. So, what is “price capitulation?”

The term “price capitulation” is a relatively new term; years ago it was called a “selling climax.” It’s a continuous price decline that builds in intensity as more and more investors throw in the towel and sell out their positions. It is usually triggered by an unexpected economic event.

The intensity of selling often comes from forced margin selling late in the movement. The 1962 bear market, the last leg down of the 1973-74 bear market, and the final leg down of the 2001-02 bear market, as well as the 2020 decline, are all examples of “selling climaxes” or moments of “price capitulation.” With capitulation, investor sentiment indicators always show maximum levels of bearish sentiment right at the climactic low.

However, there are also bear markets that end with extreme bearish sentiment without the selling climax or the moment of “capitulation.” The 1982 bear market and recession, which marked the beginning of the greatest 18-year bull market in recent history, is an example. This was also true of the 1990 bear market and recession.

I believe the current bear market is going to be one of these “no capitulation” bear markets; a bear market that slowly lifts off with everybody waiting for final capitulation.

Important Takeaway

This moment, therefore, represents a wonderful test of the theory of contrary opinion. It highlights this question:

What’s more important in the determination of stock prices: all the negative economic reasons people are stating on why the economy is moving into a recession and why stock prices will go lower; or the simple fact that so many people believe this. If the theory of contrarian is universally correct, then this in all likelihood won’t happen.

Only time will tell. We’ll visit this article one year from now to see how this all settled out.