Stock call option ratio suggests market decline is not over

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Most sentiment indicators signal that we are at the bottom of the bear market. I have pointed this out in many articles over the last two months (market sentiment articles). However, an important sentiment indicator is not there again. This is the CBOE equity puts/calls ratio, which is one of the seven components of our Master Sentiment Index.

This is very important because it measures what investors “do” and not what they “say” or “think” like the AAII and Investors Intelligence surveys. This could mean that we have another shoe to drop before this bear market ends, which finally brings up something that has worried me for some time – global systemic risk.

But first, what is the equity puts and calls ratio and what does it measure?

The put/call ratio

Puts and calls are options, with “calls” being essentially bets on rising stock prices and “puts” being bets on falling stock prices. There are many more options than this, but this will suffice for our purposes. Measuring the number of puts versus calls that investors buy can tell us a lot about what they expect from stock prices.

The put/call ratio was developed by market technician Martin Zweig and published in two articles by Barron in 1971. This was three years before the CBOE was created, so the options statistics he used were little by little. I remember the article getting a lot of noise because it was a second way to measure investor expectations similar to short selling indicators.

The indicator is based on the theory of the opposite view, i.e. stock prices will bottom out when too many people are bearish and there is excess buying of stock options. sale. Plotting the P/C ratio over time gives us a basis for determining what is “a lot” and what is “a little”.

Comparison of the Puts/Calls ratio with the SPY

The CBOE stock call option ratio (Michael McDonald)

The red line in the chart is the ratio of puts to calls for all stocks on the CBOE from 2006 to present. It does not include index options or exchange-traded funds (“ETFs”), so it is like the original index introduced by Marty Zweig in 1971. We use a 20-day moving average of daily ratios. This smooths out random fluctuations and gives us a better long-term metric. The scale is inverted, meaning high ratios are at the bottom and low ratios are at the top.

The Oct. 7 ratio of 0.75 is the highest ratio since the start of this bear market in January, but it is still below ratios that have occurred during other major lows. For example, it rose to 0.87 at the bear market low in March 2020. It also recorded 0.89 and 0.87 at two different times during the bear market of 2008-09. It is also below the levels reached during the market corrections of 2011 and 2016.

This opens up the idea that, from the perspective of this indicator, further price declines would generate more put purchases, pushing the ratio higher, generating a clean buy signal. I am now open to this idea. Normally I wouldn’t, but today there is a discernible risk that something that has worried me for some time – the Fed will trigger a global systemic event.

Global systemic risk

Systemic risk is the sudden collapse of a country’s entire banking system due to failures in interlocking financial agreements and obligations. Collapse can only truly occur when these agreements and obligations have been structured using excessive borrowing and leverage.

Collapse usually happens quickly – within days or a week – and few see it coming. The loss of $800 billion in bank capital and the collapse of the US banking system in 2009 essentially happened in just five days. It was the overnight emergency passage of the TAARP, along with the Fed’s liquidity measures, that halted the collapse and ultimately sparked the recovery.

The risk today is that something like this will happen to the global financial system. Here, however, there is no global governing body or global Fed with the power to save the system.

What scares me is that the independent actions of the Federal Reserve’s major global banks, acting in the best interest of their own country or region, could trigger such a global meltdown. Their well-meaning actions to help their own economies could backfire unintentionally.

I intuitively know that such a thing happens at some point; in fact, I wrote a Seeking Alpha article in 2010 about it. Such systemic collapse is almost inevitable with the creation of an interlocking global banking system with no one in charge. I don’t know if that’s it.

Could an overly hawkish Fed trigger global instability?

The recent strength of the dollar and the actions of the Federal Reserve to raise rates are intimately linked. Nothing pushes currencies up or down like changes in interest rates, and the dollar index is up 24% against other currencies over the past fifteen months. They don’t do it for that reason, though. They are just following Congress’s mandate to control US inflation and maintain maximum employment. A higher dollar is only a side benefit. It actually helps to reduce inflation, since the price of imported things goes down a bit.

But it can cause big problems for foreign economies. Since oil is traded in US dollars, foreign countries not only have to pay the higher oil price, but also the higher price to buy US dollars to buy the oil. It’s a double whammy. The systemic effect this may have on interlocking global economies is unknown.

But I don’t think the Fed thinks that way. If a hawkish Fed goes too fast and too far and creates a currency crisis that triggers a global event, the consequences for the US economy and financial system would be enormous. They can save the American economy, but kill it in other unexpected ways.

Summary

History shows that a bear market does not usually end with such a low sell-to-call ratio (0.75). To drive it up, further price cuts are likely needed.

What seems like a possibility today is a sudden and unexpected global crisis triggered by a Federal Reserve focused only on the US economy and not on the world stage.

The correct actions of the Federal Reserve from now on are essential. One must be on the lookout for the banking situation of any major country that could lead to a global systemic collapse. Watch especially for further rate hikes by the Fed and the effect they have on the dollar and indirectly on other global economies.

I recommend staying covered until the situation becomes clearer.

Sallie R. Loera