The chain reaction of excessive sentiment itself is predictable and almost fail-proof. However, the timing and scope is variable and harder to predict, which doesn’t mean we won’t try.
Timing and scope of decline
I monitor dozens of sentiment indicators, but to help gauge the timing and scope of an upcoming decline, I like to use the CBOE equity put/call ratio. Here’s why:
• It is an actual “put your money where your mouth is” indicator rather than a non-committal poll.
• It has reached a notable extreme.
On Jan. 10, the five-day simple moving average (SMA) of the put/call ratio fell to 0.492. This means that investors spent twice as much money on bullish call options than on bearish put options.
This is the lowest reading since June 2014 — and one of the lowest readings of the 21st century.
The red lines highlight other times the put/call ratio was as low. In January 2018, the S&P 500 took a nasty spill within 10 days of the signal, in June 2014, the decline was more delayed and less pronounced, and even less so in September 2013.
Here is another feature of the latest leg of the rally. The S&P 500 has gone 64 days (Since Oct. 9, 2018) without a move of more than 1% (based on end of day prices). The S&P 500 spent only one of those 63 days below the 20-day SMA.
The yellow boxes highlight the other two times (since 2016) when the S&P 500 went at least 64 days without a 1% move (yellow lines mark the end of 64 days) and only one day below the 20-day SMA.
All three instances mark periods of extremely strong momentum, and momentum — like a tsunami — tends to carry stocks higher than most expect.
Once the 20-day SMA failed in February and October 2018, the S&P 500 fell sharply. The same was true for the Dow Jones Industrial Average