 Put/Call
Ratio Soaring
Adam Hamilton
Archives
June 4, 2004
In just the past couple weeks,
an extremely intriguing anomaly has arisen in the US stock markets.
The famous Put/Call Ratio 21-day moving average has soared above
1.00 for the first time in at least a decade! This odd development
is vexing bulls and bears alike.
The Put/Call
Ratio, or PCR, is a powerful technical trading indicator
that monitors the stock and stock-index bets that speculators
are making at any given time. Speculators who expect individual
stocks or the indices to fall in the months ahead buy put options,
derivatives bets which increase in value when prices decline.
Speculators who expect rising prices buy call options, which
promise hefty payouts on higher prices.
The PCR quantifies the ratio
of the daily trading volume in these two opposing bets, granting
speculators valuable insights into what the majority happens
to be expecting. When the PCR is above 1.00, as today, it literally
means that the daily trading volume on puts is higher than calls.
Translated into pure sentiment terms, it indicates that the majority
probably expects lower prices in the months ahead. And since
we humans are naturally bullish, a PCR above 1.00 is an extraordinarily
rare event.
Today's high PCR anomaly is
difficult to interpret, as I will outline in this essay. Both
bullish and bearish cases can be built around this surreal development,
and the contrarian slant on this is complex as well. While I
certainly wish there was an easy bullet-proof interpretation
of this odd event, its sudden appearance today within the context
of current market conditions is a puzzling mystery.
Before we dive into these intriguing
charts, it is important to realize that the raw PCR data is immensely
volatile and not conducive to graphical analysis. The day-to-day
PCR numbers jump all over the place depending on each day's stock-market
performance.
On May 4th, for example, the
S&P 500 closed modestly higher by 0.2%, its second minor
up day in a row. As speculators were generally bullish, call
volume far exceeded put volume and yielded a PCR of only 0.67
which is pretty low. Just two days later on May 6th, however,
this three-day up streak ended with a trivial little 0.7% loss
in the SPX. Yet this spooked speculators so much that the PCR
soared to 1.26 on that day, a very high level. Even though the
markets were only down by 0.5% net in these few days, the raw
PCR rocketed higher by an enormous 88%!
Since graphing this
raw data looks like an electrocardiogram of someone overdosing
on drugs right before their heart explodes, speculators use a
moving average to smooth it out. The most common moving average
applied to the PCR is the 21 day. 21 days may sound like a strange
number to use, but it makes a lot of sense. The average month
has 21 trading days, so the PCR 21dma is effectively a one-month
smoothing of the underlying hyper-volatile raw PCR data. In this
essay, whenever I say "PCR" I am really referring to
the PCR 21dma shown in these graphs.
Our first graph this week compares
the flagship S&P 500 with the PCR 21dma in order to illustrate
the broad strategic trends. In this big-picture context it is
easy to understand how the PCR tends to behave and why the current
spike above 1.00 in 21dma terms is such a strange anomaly. These
graphs are updates from last June's "Trading
the Put/Call Ratio 2" essay.
These strategic PCR trends
really help illustrate why this ratio of options speculations
is such a powerful proxy on general sentiment. The higher the
PCR the greater the general fear in the marketplace, and the
lower the PCR the higher the general greed. Fear tends to be
the highest at Great Bear bottoms while greed waxes to unbelievable
extremes near Great Bull tops. The PCR tracks these sentiment
trends beautifully.
During the latter years of
the Great Bull surging into the late 1990s, the PCR was in a
well-defined downtrend, which makes sense. The longer the bull
lasted and the higher stocks surged, the more people grew convinced
that the bull market would last forever. Remember the deafening
cacophony of bullish hype in the late 1990s? General sentiment
swung farther and farther towards naked greed as call trading
soared while puts languished, driving down the PCR.
Provocatively the PCR carved
its long-term bottom in March 2000, just as the US stock bubble
reached it all-time peak. At the time the PCR 21dma actually
plummeted to 0.43, indicating that the trading in bullish call
volume was actually running more than twice as high as the bearish
put volume. The contrarian nature of this indicator becomes crystal
clear when you realize that just at the very moment when the
tech bubble topped and people ought to have been betting on a
coming crash via puts, calls gaming on even higher markets were
all the rage.
As the Great Bear awoke from
its multi-decade slumber soon after, the secular PCR downtrend
changed into an uptrend. In bear markets the PCR gradually spirals
higher and higher until it ultimately peaks at the Great Bear
bottom when popular pessimism is overwhelming. In October 2002
at the latest major interim lows, the PCR peaked at 0.98. This
suggested that general bearishness was so high that the trading
volume in puts almost equaled the trading volume in calls.
And since these latest SPX
lows prior to last year's spectacular war rally cyclical
bull, the PCR trend has been decaying but generally down.
From a strategic perspective, the primary trend in the PCR tends
to move in the opposite direction of the general markets. As
optimism surges in bulls relative put volume falls lowering the
PCR, and as pessimism grows in bears relative put volume rises
raising the PCR. Piece of cake so far, right? The general PCR
theory is easy and intuitive.
OK, now it gets messy. At the
very right edge of this chart, you can see the magnificent recent
spike in the PCR 21dma. It has soared above 1.00 for the first
time in at least a decade, and quite possibly ever since options
trading has only been growing popular for a couple decades or
so, almost all of which was in a primary bull market. This soaring
PCR of the past couple weeks creates all kinds of problems for
bulls and bears alike.
Zooming in to the tactical
perspective, PCR tops generally mark major interim lows in the
stock markets over the short-term as well. Each of the three
highest preceding PCR peaks, all circled above, marked major
tradable lows in both bull and bear markets. Our new PCR high
should fit into this same contrarian framework, that short-term
pessimism is far too high and therefore bullish, which would
be great news for the bulls. It might not be this simple this
time around though.
Next to the red PCR line above,
there are solid yellow arrows drawn in. These arrows represent
earlier major spikes in the PCR similar to ours today. If you
look at each of these arrows, you will note that the stock markets
had to fall hard in order to spawn the great fear necessary to
drive up a major spike in the PCR 21dma. Yet when we examine
our current PCR spike the stock markets have certainly not fallen
sharply, but fear is still soaring. Weird!
The only other time in the
past decade when we have witnessed such a massive PCR spike of
similar magnitude was during the 1998 financial crises which
rocked the US equity markets. As currencies devalued, leveraged
hedge funds like Long-Term Capital Management imploded, and the
very stability of the entire global financial system was believed
to be in jeopardy by the Fed at the time, pessimism and therefore
put buying went ballistic. It took a brutal 19.3% S&P 500
correction over only 31 trading days in the summer of 1998 to
generate the huge PCR spike from 0.58 to 0.92, a 59% increase.
Yet during today's anomalous
PCR spike, there have been no major financial crises! Foreign
currencies aren't being eviscerated, hedge funds aren't falling
from the sky like ducks on the opening day of hunting season,
and the Fed and Wall Street are not worrying about the entire
derivatives pyramid unraveling. From its latest interim closing
high of 1158 in early February, the S&P 500 had only fallen
by a slow and unimpressive 6.4% as of mid-May. Yet, the PCR has
still soared from 0.68 to 1.01, a huge 48% increase!
With the S&P 500 not even
plunging below its key 200dma this time around yet, and not having
witnessed a sharp and frightening correction, and no international
financial crisis underway, why is the PCR registering record
amounts of fear these days? What has people so spooked and what
is really going on in the markets underneath the surface? Put
volume is soaring indicating that speculators are generally expecting
lower prices ahead, but why?
These questions are very important.
In the awesome movie "The Matrix," one of my all-time
favorites, whenever our heroes were within the computer-generated
artificial-reality Matrix they carefully looked for signs of
anomalies like déjà vu, seeing the same thing twice
in a row. Such events indicated a glitch in the Matrix's fabric
and suggested something was wrong, like the bad guys were popping
into the Matrix nearby. In the financial markets anomalies work
similarly. When something weird happens it is best to pay attention
as it can be a warning or precursor, subtle yet important.
This odd PCR spike to record
highs within its current strange context may be a glitch in the
Matrix. Our next graph zooms in a bit closer, just to the Great
Bear and war-rally cyclical-bull years, in order to gain a clearer
perspective of what is happening in PCR land. We can use it to
ponder the bullish and bearish cases built around this soaring
PCR.
Since being bullish after the
powerful rally last year is the most fashionable market worldview
to hold these days, we will start with the bullish arguments.
The bullish case begins in October 2002 when the S&P 500
bottomed and the PCR topped following a brutal summer selloff.
As you can see above, the waterfall decline of mid-2002 was the
greatest plunge in absolute and percentage terms in this entire
Great Bear to date.
After bouncing a couple times
near this crucial SPX 800 level of support, war fears drove the
markets lower into early 2003. As Washington started bombing
Baghdad, however, the terrifying uncertainty leading into the
invasion vaporized. Without this oppressive uncertainty hobbling
them, the markets soared for the better part of a year, skinning
the bears alive in 2003. The bulls rejoiced over perpetually
rising profits and stock prices, and believed a new long-term
bull had been reborn out of the 1990s bull's ashes.
The PCR played along with this
bullish interpretation really well. It reached its peak in October
2002 and entered a downtrend as the markets marched higher. While
its downtrend wasn't as steep as that witnessed in major bull
markets in the past, it was still a downtrend. Relative to call
trading, put volumes dwindled as more and more bears grew tired
of being pummeled on the losing side.
While today's anomalous PCR
spike soared high enough to easily shatter the upper resistance
line of its bull-market downtrend, the bulls aren't concerned.
They point out, and rightfully so, that interim PCR highs usually
coincide with major interim lows in the equity markets. If you
look at any major PCR spike in the graph above before today's,
you will note that they always occurred just as the markets were
ending a sharp correction. And while the recent months' correction
was not sharp by any stretch of the imagination, it was still
a correction.
This short-term trading focus
suggests that today's stellar PCR is a telltale marker for a
major bottom and a precursor for much higher markets to come
in the months ahead. This short-term contrarian viewpoint is
often, but not always, right. The bulls may certainly be right
this time of course, as the markets have generally done well
leading into presidential elections in history. But the bulls
really need this PCR spike to die soon so it can quickly collapse
back into its downtrend channel. If it doesn't, they are in serious
trouble.
The bears aren't buying this
bullish interpretation of the new PCR highs, however. They point
out that never in history have stock markets carved major long-term
bottoms at valuations
anywhere near as high as they were in late 2002 and early 2003.
I remain in this camp myself, being a contrarian and believing
that the only way to consistently win in long-term investing
is to buy when stock prices are relatively and absolutely cheap
in historical context.
The recent PCR downtrend following
its late 2002 top did present a problem for the bears last year.
In theory, pessimism and put trading should be the highest at
the deepest, darkest, and ugliest days of the long-term bottom.
Sentiment should be blackest right before the dawn, and it was
certainly ugly in the summer and early autumn of 2002. But was
sentiment negative enough? I don't think so.
If you lived through the secular
bottoms of 1974 and 1982, when stocks traded at 8.3x and 6.6x
earnings respectively, and yielded 5.4% and 6.2% in dividends,
then you know what real negative sentiment feels like. At the
time popular financial magazines ran cover stories proclaiming
the death of the stock markets, and the thundering masses loathed
stock investments with a passion. If you have a university with
a business school library in your area, spend some evening reading
the newspapers and magazines from late 1974 and mid-1982 to get
a feel of how utterly hopeless real bottoms feel.
October 2002, on the other
hand, while ugly, was not a sentiment or valuation extreme by
historical standards. Stock investing never went out of favor
like it does when people have given up hope of even finding the
bottom. At these latest interim lows, stocks still traded around
26x earnings and only yielded less than 2% in dividends, almost
historical bubble levels. The late 2002 lows looked nothing like
a true, brutal, hopeless secular bottom in history where stocks
are universally hated.
Now since options trading was
not yet popular in 1974 right as it was born nor later in 1982,
no one really knows yet what a PCR would look like at a hellish
long-term market low. As I mentioned a year ago in "Trading the
Put/Call Ratio 2" however, put volume ought to exceed
call volume considerably. After all, if sentiment is at multi-decade
lows, shouldn't put buying be at stellar highs in the speculation
community? Here is a quote from last year, which incidentally
was laughed at as lunacy then
"I strongly suspect that
before this Great Bear fully runs its course that the PCR 21dma
will exceed 1.00, that over at least one 21-trading-day period
the average put volume will be higher than the average call volume.
It is hard to imagine a Great Bear ending without the majority
of market players, including the options folks, waxing overwhelmingly
bearish and extensively trafficking in put options accordingly.
A PCR 21dma over 1.00 will be necessary to mark those fateful
days when options bears finally outnumber options bulls."
The current anomalous PCR spike
has an important strategic bearish interpretation too. Since
the PCR 21dma just exceeded 1.00 for the first time, and since
this level is already higher than the PCR highs reached at the
late 2002 interim bottom, this suggests that October 2002 was
not the long-term bottom. The PCR should reach all-time extremes
at the Great Bear bottom, but the sub-1.00 levels of late 2002
have already been exceeded. Therefore they weren't the ultimate!
This bearish interpretation,
based on both sentiment and valuations, supports extending the
PCR uptrend of the Great Bear. This is drawn in with the yellow
extended rising trendlines in the graph above. If the war rally
of last year really was just an especially powerful bear-market
rally, then perhaps the PCR is now correcting back up into its
original bear-market uptrend channel. Maybe the real anomaly
is not this PCR spike, but the PCR slump that led it temporarily
below its secular uptrend in the last quarter of 2003!
If this bearish view proves
correct, then the PCR 21dma should ultimately travel far higher
than 1.00 at the true Great Bear bottom, establishing a major
new record high. If the Great Bear is indeed reawakening from
its year-long slumber to maul overvalued stocks lower again,
then today's PCR levels don't look at all out of place within
the PCR's extended secular bear uptrend channel.
Whatever the reason, fear is
soaring in the equity markets driving the Put/Call Ratio to record
highs. Perhaps it is speculators betting on a new bear downleg
buying the puts. Perhaps it is long bull investors hedging their
downside risks at these overvalued levels buying the puts. And
perhaps terrorism fears and geopolitical uncertainty are contributing
to this increased bearish interest too.
At any rate, this current PCR
anomaly bears careful watching. We will continue monitoring it
and the unfolding stock-market scene in our acclaimed monthly
Zeal Intelligence
newsletter, launching new trades as appropriate. In light of
the growing possibility that the extended Great Bear uptrend
channel in the PCR is back in play, I am adjusting our range
of interest on this key indicator up slightly to correspond with
and straddle this secular trend pipe, to 0.85 to 1.15 for short-term
trading signals.
Only time will tell whether
the bearish put buyers are correct this time around, but the
new record-high PCR levels greatly weaken the case that the October
2002 lows were the ultimate bear-market bottom.
Put buying when everyone gives
up hope and stocks trade down near 7x earnings ought to be stupendous
and not exceeded again for decades until the trough of the next
Long Valuation Wave rolls through.
June 4, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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