Negative Investor Sentiment

The market continues to appear weakened on European and US economic concerns. The S&P 500 has suffered six consecutive down days, an event that has occurred only seven other times in the past decade.

We will continue to take a defensive stance towards the market until sentiment improves. That said, we anticipate re-entry sooner rather than later. Read on.

Negative Sentiment

One item we tend to track is the American Association of Individual Investors (AAII) Sentiment Survey. Taken from their web-site, “The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.”

While we do not incorporate this model into our behavioral calculations, we track the results for certain anomalies. This survey has been used in the past as a contrarian indicator.

Market pessimism, as measured using the AAII Survey is hitting extremely oversold levels. Last week, only 23.6% of respondents to the survey claimed to be bullish compared to 46.0% that are bearish. Using a ratio of bulls-to-bears, that figure is now just over 0.5 and the four week moving average is hovering around 0.7. This model is typically used as a contrarian indicator, so bull-to-bear readings below 0.5 indicates there is extreme pessimism in the market and there may be a coming “bounce”.

More Negative Sentiment

We have also been tracking the put/call ratio. This ration has been above 1.0 (negative sentiment) for 11 of the 14 trading days in May.

The put/call ratio is the comparison of put volume relative to call volume. For those unfamiliar with how put and call options work, put options are derivative securities that move in the opposite direction of its underlying asset. For instance, if one were to purchase a put option against the S&P 500, if the index went lower, the put option would appreciate. Put options are generally used to hedge against market weakness or bet on a decline.

Call options are just the opposite. Unlike put options that have an inverse relationship with its underlying asset, call options have a direct relationship with the underlying. Call options are used to hedge against market strength or bet on advance. A put/call ratio above 1 signifies put volume exceeding call volume. When the ratio is below 1, then call volume is greater than put volume.

The theory goes is that when the put/call ratio is registering high numbers (in excess of 1.0), market sentiment is deemed bearish. If this ratio stays elevated for a period of time, one would look for clues of an oversold “skittish” market and would consider buying stocks. Conversely, when the ratio is nearing excessively low levels for a period of time, one would determine the market as too “complacent” and look to exit.

The put/call ratio is an indicator that should be used to provide contrarian alerts indicating extreme bullish and bearish cycles.

Extreme Spikes

The put/call ratio can be used to identify spike extremes that may foreshadow a market reversal. A spike extreme occurs when the indicator spikes above or below a certain threshold. Figure 3 shows the indicator with horizontal lines at 1.43 (green) and .61 (red). A spike above 1.43 is three standard deviations from the average and reflects a surge in put volume relative to call volume, which could be interpreted as excessive bearishness. This is exactly what happened last Thursday. As a contrarian indicator, excessive bearishness is viewed as bullish.

Typically, when an investor witnesses a sharp spike in the ratio, it can be interpreted that the market bottom is nearing from a recent market correction. As can be found in Figure 4, the ratio produced sharp upward spikes in September, October and November of 2008. The market did move higher from that point only to be retested in early 2009. Once that bottom took hold, the market went on to produce significant returns.

The model also produced extreme spikes in May 2010. The market ended up bottoming in June/July of that year before continuing its upward ascent.

The ratio offered extreme spikes in August and September of 2011. The bottom was reached in October of that year.

Last week we started to see extreme spikes in this model.

While looking for extreme spikes is one method of interpretation, it does have its drawbacks in that it provides very early signals and ofttimes the market continues lower from the spike point. While having an early warning system in place is beneficial for investors, we went further in our modeling and created our probability bands for the ratio.

Probability Bands

The thick orange line in figure 5 represents the fifteen day moving average of the normal distribution for the ratio. The line will stay in-between +1.0 and -1.0 for 68.27% of the observations. Our model dates back to 1997 and is updated daily. When this line ventures outside that probability zone is when money can be made in the market. The trick is to use this model in conjunction with extreme spikes to further enhance one’s ability to use this formula for profits.

Going back to our previous market entry examples, we already established where the spikes occurred. Using Figure 5, the next step would be to use this model to pinpoint a more precise entry point. Typically one wants to aggressively buy stocks when the thick orange line pierces the -1.0 probability band to the upside. Our buy points are now pushed out to Late December 2008 / early January 2009, Early July 2010 and early December 2011. As can be seen in figure 6, using the two models in conjunction will harmonize the investment decision-making process.

By using these put/call variables and incorporating the results into our overall behavioral model, we have a clear advantage in capturing directional market moves over those that merely “trade on instinct”.

Joseph S. Kalinowski, CFA