ETF Opinion: Extreme Bearishness Will Tell You When to Buy Again

It's hard to believe it, but the Dow was actually above 13000 one month ago. Today, it is having trouble closing near its lows in March. That's a pretty bad sign.

The S&P 500 is still several percentage points above the closing lows of March. The Nasdaq is 10% higher than its March bottom. Still, these facts are little comfort for investors.

Yet here's something that should provide a measure of comfort. There's been a fairly reliable indicator for buyers since the credit crisis initially slammed stocks in August of 2007. It's the equity put/call ratio.

Puts represent those who short the market (i.e., selling in the options pit), while calls represent those who are long or buying. A large volume of puts relative to calls has a long history of signaling extreme bearishness... and extreme bearishness is historically indicative of a purchasing opportunity.

In fact, there's a magic number for the ratio... 1.0 or higher. Whenever the volume of puts is equal to or greater than the number of calls, pessimism has typically peaked.

Need proof? The put/call ratio exceed 1.0 from August 14 to August 16 of 2007. The market was in virtual free-fall. But on August 17, 2007, the Fed lowered its discount window 50 basis points, and the market rebounded to new highs in October 2007.

The second time that the put-call ratio exceeded 1.0? January 15, 2008. Once again, the market seemed on the brink. Many of the days that followed witnessed put/call ratios of .99 and .98. Finally, on the 22nd, the Federal Reserve served up a 75 basis point emergency cut on January 22. The markets rebounded in February.

The third time that the put call-ratio surpassed 1.0 was a doozy. It happened on 3/6... and it remained near that level for a week. Then the Bear Stearns (BSC) rumors kicked in, and the put-call ratio hit 1.16 on 3/14 and 1.35 on 3/17. (I could not find a single put-call ratio in the 5 years of CBOE data as high as 1.35.)

March 14, 2008 was, of course, the Fed orchestrated bailout of Bear Stearns. And after the smoke settled over the next few days, the markets decided the bailout was a good thing. By April and May, the markets had nearly recovered their 2008 losses.

So here we go again. With unemployment ticking higher, gas prices going through the roof, home prices cratering and banking still plagued by bad debt on the books, more options investors have been expressing short interest (puts). Through June 19, however, we are closer to a 10-day moving average of 0.80 on the put-call ratio. (Note: Until the markets close, we won't know what the 6/20 ratio will be.)

Since the credit crisis first reared its ugly head in the stock market circa August 2007, the put-call ratio has told us when we might want to be acquiring shares. However, oil at $135+ has thrown a new wrinkle into the narrative. Moreover, the Fed doesn't have as many attractive options as it had on the last 3 go-arounds.

Will the put-call ratio be as potent going forward? I believe that it will, regardless of the economic challenges and changing circumstances surrounding the increased pessimism.

Nevertheless, we still have to know what's on our "buy list" if and when we see a 1.0+ put-call ratio. Investors have yet to be handsomely rewarded by purchasing financials or consumer discretionary stocks.

(The "reverse wealth effect" is making it more difficult for early business cycle leaders. Indeed, housing may need to show several months of price stabilization before genuine sector rotation will occur.)

In the meantime, it may make the most sense to consider the best rebounders from previous market lows; that is, we might expect leadership from the old guard in energy, utilities, technology and materials. Personally, I prefer global select sectors like the iShares Global Materials Fund (MXI) and the iShares Global Technology Fund (IXN).

Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[Pauly B]

Thanks for the great post.

It helps to remind me every-time I click the mouse to sell there is someone else on the other-side of the trade buying.

[Bear Stocks Report]

Commodity ETFs like DBC, GSP and XME are still going great guns.

[JimG]

Where do you easily find the put/call ratio?

[Indexor]

The CBOE "Total" Put/Call ratio to the S&P 500 closed Friday at 1.33, up from 0.98 the day before. In the past 10-months, it reached a high of 1.53 on August 16, 2007. Its recent low of 0.57 was recorded on December 21, 2007. Its 10-month average is 1.03, median 1.01 and standard deviation 0.16. The average norm has been 0.75 since 1995.

For a simple perspective, this contrarian indicator represents the number of Put contracts divided by the number of Call contracts. A number above 1 indicates more Put buying, which is Bullish. And, of course, being a contrary indicator, a number below 1 indicates more Call buying, which is Bearish.

[datalink1995]

What chart is he reading? March S & P 500 ended at 1323.

[Indexor]

Sorry for the additional post. One place the CBOE "Total" Put/Call ratio to the S&P 500 can be found is at stockcharts.com under the symbol $CPC. If you choose the Point & Figure chart method, you can change the dates going all the way back to 1995, to backtest how this indicator responded to both fear and greed within the US large capitalization stock market, and what the eventual outcomes were.

[gordon]

Why not follow it on a chart? It's the same, basically as the $VIX, which is close to breaking above 25, if it does, it could go to 30, but "capitulation&quo... is at 35 or above,
stockcharts.com/h-sc/u...=$VIX&p=D&yr=1...

because the Plunge Protection Team, aka Paulson, has opened a window for trading desks to borrow at 2.25% and TRADE COMMODITIES and buy SPY/DIA futures to prop the market. Since Paulson came on board from Goldman Sachs, the broker-dealer's "trading profits" have skyrocketed. Why is no non-dumbass reporter on this website pointing out the broker-dealers are being subsidized by the Fed at 2.25% $21 BILLION PER DAY LAST WEEK! and there is no oversight as to their role in pushing up oil futures, they are using this money to trade commodities, they are NOT LENDING IT OUT.

[gordon]

Sorry- here's the $VIX chart I referenced, tinyurl.com/66ec9t

[karmaguy]

Gary, You may be playing a dangerous game of chance. By your own submission the Put/Call ratio as measured by the last 5 years of data has been recently hitting new all time highs. So, where's your buy-in point now? When it hits 1.00?? Let's say the S&P is trading at 1260 (March lows) at a reading of 1.00. Are you going to buy? But if the Ratio expands to 1.35 or say a new record of 1.45 then where do you think the S&P will be then. I'll tell you, 900!! Are you prepared to tell people to buy at 1.00 and then face that kind of potential loss? I think not! So what do you do? Buy some stocks when the Ratio hits 1.00, buy more at 1.10, more at 1.20, more at 1.30 and even more at 1.40? I think not! That would be like all those out there that have been trying to guess the bottom on the Financials.

[Indexor]

Good post Gary. Here are a few stats on the $VIX. Over the past 10-months (200-days) it reached a high of 32.24 on March 17, 2008. Its low of 12.78 was on June 1, 2007. Its 200-day average is 21.80, median 22.44 and standard deviation 4.35. Since 2000, its high was 45.08 on August 5, 2002. Its low was 9.97 on December 14, 2006. Its median since 1990 has been 19.00. $VIX is generally considered Bearish when it is above 25 and becomes Bullish below 20.

[Indexor]

Karmaguy - here's one solution for you. Like most dynamic indicators, why not smooth the results using a simple moving average. The current 200-day moving average is "Neutral" at the moment