U.S. stocks have extended the fourth quarter’s gains this year, and investors expect the party to continue.
Ironically, this kind enthusiasm is the stock market’s biggest enemy.
The math and crowd psychology behind any supply-and-demand-driven market can be boiled down to this simple chain of events:
• Rising prices make investors overly optimistic.
• Buyers convert into owners (owners can only sell, not buy).
• Fewer buyers are left to bid up prices.
• Sellers will eventually outnumber buyers.
• Prices decline.
I discussed the exact inverse (excessive pessimism) of that chain reaction in October 2018: “Today’s stock market pessimism is a reliable sign of a pending rebound.”
The S&P 500 Index SPX, +0.70% has rallied about 10% since then.
The chain reaction of excessive sentiment itself is predictable and almost fail-proof. However, the timing and scope is variable and harder to predict, which doesn’t mean we won’t try.
Timing and scope of decline
I monitor dozens of sentiment indicators, but to help gauge the timing and scope of an upcoming decline, I like to use the CBOE equity put/call ratio. Here’s why:
• It is an actual “put your money where your mouth is” indicator rather than a non-committal poll.
• It has reached a notable extreme.
On Jan. 10, the five-day simple moving average (SMA) of the put/call ratio fell to 0.492. This means that investors spent twice as much money on bullish call options than on bearish put options.
This is the lowest reading since June 2014 — and one of the lowest readings of the 21st century.
The red lines highlight other times the put/call ratio was as low. In January 2018, the S&P 500 took a nasty spill within 10 days of the signal, in June 2014, the decline was more delayed