Lowest Put-Call Ratio In 3 Years Suggests Near-Term Caution Is Warranted

 |  Includes: SPY
by: Chris Puplava

Summer is officially here. The kids are out of school and families are beginning to embark on summer vacations. Everyone is in a good mood, particularly investors when looking at equity put-call ratios.

Currently, the 10-day moving average for the CBOE equity put-call ratio rests at 0.50, the lowest reading seen since the spring of 2011 which marked the top before a nasty correction in the summer. When we have seen sentiment this overly bullish over the last five years future returns in the coming months have not been pretty.

Just take a look at the green boxes below which highlight the periods when the ratio has been this low in the past (shown inverted in the chart in red below), which have also corresponded to peaks in the market.

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What is also of concern is that we have a low put-call ratio at the same time we are seeing negative divergences in 52-week highs as fewer and fewer stocks participate in the rally. As seen below, whenever we see a negative divergence between stocks hitting 52-week highs and the market, we typically see a short-term top follow as highlighted by the yellow boxes below.

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While I expect some short-term weakness, I expect the downward price action to not be a prelude to a sharp correction as was seen in the summer of 2010 and 2011. Inflation, while rising, is not doing so to the degree we saw then, which hurt both consumers and businesses, and so I do not think we will get the same economic slowdown that was associated with those summer corrections.

Additionally, I am not seeing the same negative divergence between the stock market and the credit markets that we saw in 2010 and 2011.

Typically, the credit markets peak and trough ahead of the market and thus often serve as an early warning of a market decline. This was the case in 2010 and 2011 where credit default swaps (CDS) on investment grade and junk corporate bonds were beginning to rise while the stock market continued to rally. The CDS swaps on corporate bonds in both years were sending a big warning flag for anyone listening. In 2010, the CDS on corporate bonds not only warned of the May-July correction, but also the formation of a bottom as the CDS began to come down while the market was still declining, setting up a positive divergence.

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Looking at the present situation, we do not see any divergences between the CDS on corporate bonds and the stock market as both are confirming each other. That is why if we do see any weakness I believe it will be mild and short lived.

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The focus of this article was on the near-term outlook for the market in which there is some concern that we could see weakness in the days and weeks ahead. Currently, CBOE equity put-call data is the lowest we have seen since the levels that preceded the big declines of 2010 and 2011. Another red flag that is beginning to surface is a negative divergence between the market and 52-week new highs, which have been declining since early June.

While we saw large corrections in 2010 and 2011 when CBOE equity put-call data was this low, we also saw a big red flag from the credit markets which were not confirming the market’s move to new highs and correctly warned of the summer correction. However, we are not seeing the same warning signs from the credit markets presently, which is why I think any weakness in the days and weeks ahead will be mild and short-lived.

Disclosure: None