Stock market indicator that predicted 1987 crash flashes red again

AIn the midst of a historic stock rally, millions of Americans have bought and traded stocks. But at least one key market indicator suggests the party might not last.

A widely followed indicator of what Wall Street calls “investor complacency” has been a warning signal since early November. The CBOE stock put-call ratio measures the number of bearish to bullish stock market bets in the options market. The lower the number, the more optimistic investors are.

On November 8, the ratio hit 0.36, one of the lowest since 1999. While fears triggered by the new COVID-19 variant Omicron led to a rise this week, on Wednesday it was 0.52 , still low by historical standards.

Which may surprise you: Many experts actually take extremely low readings as a warning sign, as they suggest enthusiastic investors may have offered stock prices above what is really justified by corporate earnings. .

Also, at present, the gauge of convenience reflects a softness in the 2021 rally that is not in keeping with stock market history, said Oliver Pursche, vice chairman of financial advice Wealthspire.

“We haven’t had a 10% market correction in a while, and these tend to happen once or twice a year,” Pursche explains.

Speaking at a Bloomberg conference earlier in November, Goldman Sachs Group chief executive David Solomon said greed had recently “overtaken” fear in the market, a complacency which he said often presaged. painful periods.

How the put-call ratio works

The CBOE stock purchase ratio is calculated by taking the total number of conservative puts written each day on the Chicago Board Options Exchange and dividing by the total number of bullish calls written. It was invented by a man named Martin Zweig, who cemented his reputation by using it to predict the crash of 1987.

A purchase option is a contract that allows the holder to buy a certain number of shares if the price closes at or above a certain level, making it a bullish position as the contract increases in value if the stock goes up .

A put option is often considered “portfolio insurance” because it offers the right to sell a certain number of shares at a fixed price, even if the market price drops below that level, and it therefore earns. the value if a stock goes down.

According to Zweig’s contrarian theory, imbalances in the volumes of the two are a testament to market sentiment. When puts far outweighs calls, panic reigns and now is a good time to buy stocks. When the demand for call options greatly exceeds the demand for puts, as is currently the case, complacency reigns and this indicates a speculative peak.

How accurate is the put-call ratio?

The long-term average put-call ratio for CBOE stocks is around 0.7. Opposites start to worry when it drops below 0.5, which suggests that twice as many bullish calls are trading than conservative puts. This usually only happens under very calm and stable stock market conditions.

“Stability breeds fragility,” as strategists at brokerage firm Bank of America Global Research put it in an August research note.

The CBOE share buyback ratio was one of the only red flags before the infamous Black Monday crash of October 19, 1987. Zweig, its inventor, was one of the few financial professionals to warn that a massive sale could be near.

It also sent signals ahead of the 2008 financial crisis, hitting a multi-year low of 0.46 in October 2007, which turned out to be the month the bull market peaked.

There was a false alarm, a brief drop to 0.32 in 2010. The next time it approached that low was in January 2020, when it hit 0.44, just right. before the Covid stock market shock.

What a low buy-to-sell ratio means for the market

This time around, there are plenty of other signs that investors are extremely bullish – and that a correction could be imminent.

In addition to options traders, who are usually professionals, Main Street investors have invested money in mutual funds and trading applications like Robin Hood.

Meanwhile, the average S&P 500 stock is trading at a price almost 40 times higher than its average earnings over the past decade. This is the highest level ever recorded, with the exception of the period just before the Dot-Com crash in 2000.

Pursche, of Wealthspire, said the sentiment imbalance may well indicate a 10% correction, but he didn’t think the current bull market was close to expiration. The economic context has not yet changed, despite speculation about the threat of the omicron variant of Covid 19.

“Sentiment matters a lot in the short term, fundamentals matter a lot more in the long term,” says. Pursche.

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