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June 04, 2004

Put/Call Ratio Soaring
by Adam Hamilton

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.

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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