S&P 500 Put/Call Ratios Turn Bullish Again to Begin A Precarious Summer Rally

By Dr. Duru written for One-Twenty

June 3, 2009


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Monday was fun for the bulls. Wednesday was fun for the bears. If not for a 15-minute buying spree into the close, the market would be resting right about where it started the week. In late April, I claimed the following: "As the S&P 500 continues to toy with the 875 resistance level, I would not be at all surprised to see at least one false breakout to 900 or so and several 'false' breakdowns that complete a circle of frustration for bears and bulls." From there, we rallied to 930 before getting the first oversold correction of this entire bear market rally. The put/call ratios on SPY, the SPX, and the OEX (S&P 100) all spiked toward 52-week highs (in ranking) right as the correction began. However, within days, these ratios fell right back to the lower halves of their respective ranges. This extremely sharp reversal occurred as the S&P 500 staged an impressive 3% rally the day after options expiration (coincidence? I think not...!). Since then, the put/call ratios on various S&P 500 instruments have diverged (see Schaeffer's investment research for the charts and rankings): the put/call ratio on the SPX continues to languish in the 30% rank for the past 12 months, but the put/call ratio on SPY and OEX have crept back upward. The OEX is even right back to year highs. To break this "tie", I turned to the CBOE equity put/call ratio which excludes the action of the indices. This ratio has been declining for much of 2009 and now sits comfortably at levels last seen in late 2007, the end of the last bull market. (For emphasis, click here to see the 21-day moving average over the last 6 months). So, I think it remains safe to assume that market participants expect even higher prices to come in the near future.

Typically, traders use these ratios as contrarian indicators. For the past year or so, these ratios have confounded expectations by moving inversely to the overall market direction (with a few specific exceptions). With bullish sentiment beginning to catch up to bullish price action, I am suggesting that the rally has now entered its most precarious phase yet. From my general reading around the financial media, several presumed truths that serve as gospel for the increasingly bullish sentiment:
  1. The recession is near an end, if not already over.
  2. Sustained high levels of unemployment will not impede robust profit growth (I guess companies can continue to fire employees to grow profits and achieve maximum operating leverage. A jobless prosperity.)
  3. Sustained high levels of unemployment will not further crimp future consumer demand for goods and services, especially the demand for foreclosed homes.
  4. Big money institutions - pension funds, hedge funds, and the like - are now forced to buy into this market to maintain proper bond/equity balances and/or to chase performance. (A corollary truth for bears is that quants and trading programs stuck on "buy" are driving prices upward).
  5. Two weeks ago, I would have added: the economy can recover robustly without inflationary pressure. However, the natives are starting to get restless on this count as seen in Treasury yields and spiking commodity prices. As a corollary, bulls could just as well believe that the Federal Reserve will deftly withdraw excess liquidity from the strong economy at the exact right time, perfectly balancing inflation with growth.
These increasingly optimistic assumptions are converging with strong price action and with complacent options action to stirup a precarious brew. In particular, truth #4 generates the most complacency because it provides the comforting feeling that the strong bids underlining this market will remain for the foreseeable future. But just as forced selling leads to a wash-out, forced buying leads to a blow-out. With so many technical indicators remaining stubbornly in over-bought territory, there is no telling when or how that blow-out will come only that it will (should) come sooner than later. As of today, not only has the percentage of stocks above their 40DMA (T2108) maintained a VERY historic run above 70% at 44 days and counting, but also the percentage of stocks above their respective 200DMAs (T2107) is now at 63%. This indicator was last this high during the summer of 2007, right before the last bull market ended. I will be monitoring whether the OEX leads other put/call ratios higher or whether it succumbs once again to bullish pressures. The CBOE equity put/call ratio cannot provide any new information until it finally crawls back upward.

Clearly, the momentum continues to favor higher prices from here - even if the market spends a lot of time churning up and down between various support and resistance levels. Maybe the S&P 500 gets as high as 1050 this summer (as the venerable Doug Kass expects - note well he considers himself neither bull nor bear, just opportunistic). At those levels, the significant correction I still expect in the Fall may "only" mean a drop back to 800 or so on the S&P 500. If so, I am sure such a correction will be warmly greeted as healthy - and at that point, I will try my best to resist the urge to use such attitudes as new reasons for bearishness.

Be careful out there!

{Click here for an interesting analysis of the relationship between the S&P 500 and the OEX by MarketSci Blog.}

Full disclosure: long SDS, long SSO calls. For other disclaimers click here.

© DR. DURU®, 2009