ETF Expert

It’s hard to believe it, but the Dow was actually above 13000 one month ago. Today, it is having trouble closing near its lows in March. That’s a pretty bad sign.

The S&P 500 is still several percentage points above the closing lows of March. The Nasdaq is 10% higher than its March bottom. Still, these facts are little comfort for investors.

Yet here’s something that should provide a measure of comfort. There’s been a fairly reliable indicator for buyers since the credit crisis initially slammed stocks in August of 2007. It’s the equity put/call ratio.

Puts represent those who short the market (i.e., selling in the options pit), while calls represent those who are long or buying. A large volume of puts relative to calls has a long history of signaling extreme bearishness… and extreme bearishness is historically indicative of a purchasing opportunity.

In fact, there’s a magic number for the ratio… 1.0 or higher. Whenever the volume of puts is equal to or greater than the number of calls, pessimism has typically peaked.

Need proof? The put/call ratio exceed 1.0 from August 14 to August 16 of 2007. The market was in virtual free-fall. But on August 17, 2007, the Fed lowered its discount window 50 basis points, and the market rebounded to new highs in October 2007.

The second time that the put-call ratio exceeded 1.0? January 15, 2008. Once again, the market seemed on the brink. Many of the days that followed witnessed put/call ratios of .99 and .98. Finally, on the 22nd, the Federal Reserve served up a 75 basis point emergency cut on January 22. The markets rebounded in February.

The third time that the put call-ratio surpassed 1.0 was a doozy. It happened on 3/6… and it remained near that level for a week. Then the Bear Stearns rumors kicked in, and the put-call ratio hit 1.16 on 3/14 and 1.35 on 3/17. (I could not find a single put-call ratio in the 5 years of CBOE data as high as 1.35.)

March 14, 2008 was, of course, the Fed orchestrated bailout of Bear Stearns. And after the smoke settled over the next few days, the markets decided the bailout was a good thing. By April and May, the markets had nearly recovered their 2008 losses.

So here we go again. With unemployment ticking higher, gas prices going through the roof, home prices cratering and banking still plagued by bad debt on the books, more options investors have been expressing short interest (puts). Through June 19, however, we are closer to a 10-day moving average of 0.80 on the put-call ratio. (Note: Until the markets close, we won’t know what the 6/20 ratio will be.)

Since the credit crisis first reared its ugly head in the stock market circa August 2007, the put-call ratio has told us when we might want to be acquiring shares. However, oil at $135+ has thrown a new wrinkle into the narrative. Moreover, the Fed doesn’t have as many attractive options as it had on the last 3 go-arounds.

Will the put-call ratio be as potent going forward? I believe that it will, regardless of the economic challenges and changing circumstances surrounding the increased pessimism.

Nevertheless, we still have to know what’s on our "buy list" if and when we see a 1.0+ put-call ratio. Investors have yet to be handsomely rewarded by purchasing financials or consumer discretionary stocks.

(The "reverse wealth effect" is making it more difficult for early business cycle leaders. Indeed, housing may need to show several months of price stabilization before genuine sector rotation will occur.)

In the meantime, it may make the most sense to consider the best rebounders from previous market lows; that is, we might expect leadership from the old guard in energy, utilities, technology and materials. Personally, I prefer global select sectors like the iShares Global Materials Fund (MXI) and the iShares Global Technology Fund (IXN).

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