Market Sentiment’s Put/Call Ratio Went Crazy in November: What Can It Mean?

The Put/Call Ratio (PCR) – the daily volume of put options compared to call options on the Chicago Board of Options Exchange – is one of the most accurate indicators of stock market sentiment (optimism vs pessimism ), which is closely watched as a harbinger of future trends. Thus, an extremely high PCR on September 23, 2022 was a strong buy signal. In fact, he correctly predicted a major market rally, which started a week later and led to a 20% rise in the Dow (so far).

But last month, the PCR went haywire. It generated a bizarre pattern of repeated and massive spikes in pessimism, spaced out by several days throughout the month – reaching levels well above the September event, higher than any previously recorded metrics.

Nothing like this has ever happened before in the history of this indicator.

What does that mean ? It looks like something “technical” – but what? And if it is not just technical, if it conveys something real and important to the market and the economy, then what is the message?

The Report Definition

PCR is simple and accurate. The CBOE reports options volumes daily. When traders buy Put options – the right to sale a stock in the future, at a particular price that is lower than the current price – this reflects the direct belief that the stock price will fall. A high PCR can reasonably be considered to be the expression of a negative feeling. When traders buy Call options – the right to to buy actions at a certain price – it expresses positive feeling. If put options outnumber call options – that is, if the put/call ratio (PCR) is greater than 1 – it means the market is bearish. If it is well below 1, investors are said to be generally bullish.

And here is the important point. Most sentiment measures are opposite. Empirically, this turned out to be the case here. A high Put/Call ratio is – unexpectedly – ​​a strong buy signal. Unlike many other expressions of sentiment, RAP is quantitatively accurate and timely. It is updated daily. And it’s more than just an expression of opinion. The Michigan Consumer Sentiment Index (to take just one example) is based on a survey, which is of no consequence to respondents. PCR is a staked bet, backed by cold money and the prospect of real gain or loss.

The September PCR peak

On September 23, the global Put/Call ratio reached its highest point in years – reaching 99^e percentile signaling the extreme pessimism of investors. The Dow bottomed out the following week and the rally began.

The market has gained around 20% since then (until December 2). It was enough for Barrons to announce a “new bull market”.

Academic research supports the general validity of contrarian interpretation of PCR, especially at extreme values. A very high PCR – strongly reflecting negative market sentiment – ​​is a reliable signal of an upcoming rally. Over a period of 15 years, a “peak” of PCR (a reading in the 95^e percentile or more, or more than 2 standard deviations from the mean on the upper side) was followed, on average, by significant gains in the following quarter.

Options trading is an expression of sentiment, and traders are usually wrong. 80-90% of retail options players lose their bets. When Puts greatly exceed Calls, misplaced pessimism is a useful signal, if the sign is reversed.

The November Hurricane: What Happens Next?

The global PCR is composed of several elements. Separate PCRs are calculated for indices (like the S&P 500), ETFs (exchange-traded funds), VIX (volatility index), and stocks (individual stocks). Stock PCRs reflect a rather higher level of overall optimism, typical of retailer sentiment, compared to other categories. Individual investors are generally optimistic. Therefore, the stock PCR almost never exceeds 1.00. From January to October of this year, the average PCR for stocks was 0.64. Call options dominated. The PCR traded below 1.00 every day except September 23rd.

In fact, until a month ago, the ratio exceeded 1.00 on just 2 days in the last 5 years: September 23, as indicated, and March 12, 2020 (the pandemic shock).

But November broke all patterns. The stock PCR has jumped above 1.00 five times in five weeks. On November 16, it hit an all-time high of 1.46.

This was 7.4 standard deviations above the long-term mean. In statistical terms, this means that if this were truly a random market pricing process (as Professor Malkiel of Random-Walk-Down-Wall-Street would put it), such an event would occur about once every trillion years. This is clearly no coincidence. These overvoltages must have real information value.

But what information do they contain? Superficially, as we have seen, the high PCRs are read as an expression of extreme pessimism, much more intense than last September. The classic interpretation would suggest a huge market rally in the next 90 days. But the pattern is unprecedented and may not be easy to interpret. It’s too extreme not to have an important meaning. But at the moment it is uncertain.

---

---

I guess we’ll have to wait and see. Regardless of these indicators, my instinct is that a major rally is in store. But this strange pulsing signal in the PCR is mysterious. It does not appear to be correlated with “news”, external shocks or patterns elsewhere in the financial system. The stock market has not been particularly volatile. The VIX (equity volatility index) fell during the month of November and fell back below its long-term average. Bond market volatility also declined throughout the month. November did not bring any major political or economic shocks, with the exception of the US midterm elections – which were shocking only to not be shocking. After the election (which sent the S&P 500 up about 5% over several days — a typical expiration of reduced uncertainty), the index was flat for the rest of the month.

All of this can remind us that the market is mutating. Yesterday’s patterns can suddenly change. Yesterday’s models no longer work. Yet investors and (especially) academics tend to assume that the market is an invariant system, operating according to fixed laws. This Newtonian assumption is periodically contradicted and perpetually resurrected.

This may signify an imminent change in the market regime. Perhaps regime change is in the air, in many quarters. Should we consider a Russian defeat in Ukraine? A change of administration in China? Or even – most outlandish of all – a policy shift at the Federal Reserve? Who knows? But Something must be standing.

---

For more on the PCR metric, check out my previous column on the September PCR push: The Put/Call ratio says “Enter the market now!”