Wednesday, February 17, 2010

Yves Lamoureux - The Amazing Shrinking Put/Call Ratio!

Yves was kind enough to share some more of his fine work. Here he is seeing the compression of the put/call ratio. As this ratio heads lower, it tends to show complacency and often marks tops - not a perfect correlation, but that is the trend. As it heads higher it shows fear and often marks bottoms. Just look on his chart how the turning points tend to line up with turns.

This is compressing, meaning that we have been getting further from the standard in the complacent direction. Can it mean that it will take a proportionately stronger move in equities to get it back into historic ranges? Hmmm… just another clue, and Yves, as usual, is sniffing them out!

The Amazing Shrinking Put/Call Ratio!

by Yves Lamoureux, Macquarie Private Wealth

Have you noticed lately the behaviour of the put/call ratio? Once you read the next few lines, you will agree with us that it is a rare event.

We have tracked this interesting behaviour since 2007. It is a compression event taking place in the ratio. You will notice it from a quick glance at our chart.

The put/call ratio is usually defined between a mathematical range. The best example is provided at the left of the graph. The ratio will bounce around from the mean to +3 standard deviation on a sudden drop of the Dow Jones, taking it to under 13,000.

That would be normal behaviour. In our present circumstances, something very different is happening.

The Dow started a downward trend in 2008. Sentiment is responding in a very different manner this time. With each successive drop, negative sentiment will rise less. The red arrows provide evidence of the high that was reached. From drops in the stock market beginning in early 2008, the P/C would only get to +2 standard deviation. The phenomenon continues as the ratio gets progressively compressed.

Movements in stocks toward the fall of 2008 got to + 1 standard at best.

I find the behaviour of this ratio in 2009 extremely interesting. The market’s rally provides further reduction in the swings. The P/C ratio fluctuates in an even more dramatically lower range. You will find the drifting between -2 standard deviation and the mean.

Remember that the recent high in January 2010 reflects a higher level of comfort, circled in purple, than investors felt at the 14,000 peak established in 2007.

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