Which Way is the Market Headed? And How Can We Tell?

We watch a variety of statistics to help us evaluate risk in the market, and the best times to be buying and selling securities. In the last newsletter we focused on dividend yield as an indicator of a market ready to retreat, and concluded that it no longer appears to be a good one. (Read theĀ old article, if you care to.) In this newsletter we will focus on another indicator, which has a good record of predicting up markets – the Put/Call ratio. To understand the ratio, it may be helpful to provide some background for some of our readers.

Without going into a lot of detail about how puts and calls work, note that puts and calls give their owners the right to buy or sell a security at a stated price. Calls are purchased usually by speculators who believe that the market is going to go up, and puts are purchased by those who believe that the market is going to go down. An investor will buy calls or puts on a security rather than purchasing the security outright, because they can control a larger number of shares for the same amount of money (leverage).

There are usually more total call contracts outstanding than put contracts; therefore, the put/call ratio is usually less than 50%. A high ratio of 75% means that there are 75 put contracts outstanding for every 100 call contracts. There have been only 11 times since 1985 that the ratio was above 75%. Historically, a higher ratio (the more puts outstanding relative to calls) signals a market bottom; a good time to buy or hold, but not a good time to sell.

Just how good is this indicator at identifying a rising market? Let’s look at the record since 1985:

One Year After Put/Call Ratio > 75%, S&p 500 Data
Put/Call Ratio Signal Date One Year Gain (%) Days After Signal Worst % Loss During Year at Low Point Days After Signal
136.2% 12/03/87 23.23 224 -0.57 1
75.1% 10/10/90 26.34 223 -1.64 1
78.6% 1/08/91 33.17 250 -1.08 1
78.8% 10/05/94 28.27 242 -1.78 45
82.5% 7/15/96 45.09 248 -0.5 7

The table seems to confirm that a put/call ratio is a good indicator of when the market may be oversold, and on its way up. Every time the ratio has been above 75% since 1985, the market has ended higher after a year. According to the table, it took 220 days or more to reach the high and there was a small percentage drop during the year, often right after the signal was reached.

The most recent reading above 75% (actual reading was 85.5%) was on 12/19/97 when the market closed at 946. If these same relationships hold true, then we can expect a low over the remaining 9 months of around 930 (an 11.3% decline from where we were at the end of February), and expect another year of good returns.

We should note however, that this is not the only indicator we use at BWFA. Since estimates of corporate profit growth, upon which the price of stocks is ultimately based, are in the range of 7% for 1998, we believe that more modest growth in stock prices seems to be most probable.