Rough Road Ahead for an Overly Bullish Stock Market?

by ETFguide | January 14, 2014 9:44 am

It’s no secret that stock market sentiment over the past year has been stuck at bullish extremes. Sentiment surveys, record margin debt, fear measurements, breadth, etc. have all flashed bullish warning signs at one time or another.

This time around, we can add another sentiment extreme to the mix, courtesy of options traders.

Put / Call Ratio

The CBOE releases each day the data showing the number of puts, calls, and volume traded of each on their options markets.  This data helps analysts determine if options traders are overall bullish or overall bearish.

That data is summarized in the chart below and shows the extreme level the options market hit recently, at the end of 2013.

The red line in the primary section of the chart displays the Put/Call Ratio’s weekly average while the blue line displays its four week moving average.

The weekly average is reaching levels only seen a few times since the rally that started in 2009 kicked off.  The four week average meanwhile has just closed at its lowest level since 2005.

This shows that options traders own an abnormally low level of puts compared to calls and suggests that options traders also have joined the other groups of investors by becoming one-sidedly bullish.

Put Call Ratio updated[1]

A Warning, but not a Signal, yet

On the surface these extremely low levels seem like a dire warning sign, but looking back at history provides some perspective.

At the end of every year since 2009, the one week ratio has always spiked into very bearish territory, sometimes offering an opportunity but also sometimes providing a false signal (with no accompanying market decline).  This is shown by the red arrows on the graphic.

Highlighted by the red circles on the top graph showing the S&P 500, those end of year spikes that actually turned out to be a good warning are shown.  At the beginning of 2010 and 2011 this indicator provided a good warning, but at the beginning of 2012 and 2013 it did not.

So with the beginning of 2014 also spiking lower, what should we expect?

Given its history surrounding year ends, for now I would not put too much weight on the bearish reading, but if this low reading again occurs at a time not accompanying year end, then it likely would be much more meaningful as spikes lower not surrounding the year end have quite often accompanied market peaks.

Also, given the 4 week moving average (the blue line) is making 8 year lows, if it does not quickly rebound as it has done all previous times it hit such low levels, it will likely turn out to be a signal warning of a market environment different from previous year ends.

Sentiment Extremes

Sentiment extremes alone don’t create changes in the market’s (EEM[2]) trend, but they do help warn of markets that are ripe for trend changes as these signals indeed are almost always in place at major market turning points.  The 90’s tech bubble is an obvious example, but sentiment extremes also accompanied the ’06 top and the ’09 market bottom.

In a 2013 issue of our ETF Profit Strategy Newsletter we examined sentiment as measured by over 25 indicators tracked through time at these key market turning points.  An example of this is displayed below and displays a few sentiment survey levels at key market turning points.  The recent peak shows that sentiment had already reached or was very near all time highs and compares those levels to the opposite end of the spectrum in ‘08’s market lows.

sentiment snapshot[3]

Other measurements (VXX[4]) included in the analysis were a “smart money” versus “dumb money” section as well as examples why sentiment helped mark the peak in gold (GDX[5]) in 2011 as we explained,

“The peak in pop culture’s obsession by the public with gold (NUGT[6]) came right around the time that gold prices peaked at $1900 in 2011.  We don’t see it as a coincidence that Pawn Stars was the 2nd highest rated television show in ’11 just as Gold Rush:Alaska was in its inaugural season, right when gold prices topped out.”

Since that warning in our newsletter, gold has fallen another 20%, and in our latest Newsletter released 12/20 when GLD (GLD[7]) was trading for $116 we provided an update on gold sentiment and show why we think it is actually time for traders to get bullish again.  That trade is already up over 2%.

Where to From Here?

But just because sentiment extremities exist does not mean the market can’t power higher in spite of them.  The timing with sentiment is always the tricky part as Alan Greenspan’s famous “irrational exuberance” statement from 12/5/96 proves in hindsight.

It took the market another two years before topping, even with sentiment sitting at such bullish extremes for so long.  Starting in ’05 and ’06, many were also aware that the housing market was extremely exuberant.  It too took a year or two as well for those sentiment signals to finally come to fruition in falling prices.

Similarly, stock market sentiment by many measurements has again remained extremely bullish for over a year now, but thus far the market has not changed its trend.

This is why we also use technicals as well as fundamentals in combination with sentiment to help stay on the correct side of the market (IWM[8]).

Currently, equities (SPY[9]) are ripe for a change in trend based on a plethora of sentiment signals, but the technicals have yet to confirm a breakdown in a trend.  Until that occurs, sentiment will only be flashing a warning sign for the bulls, not an outright sell signal.

Check out the ETF Profit Strategy Newsletter[10] to see why we are watching the 1821 level on the S&P as our first key level to warn of a market where the technicals may finally join sentiment and fundamentals that are already flashing warning signs.

Follow us on Twitter @ETFguide[11]

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