2. Sentiment. While valuation is important, investors should also pay attention to sentiment. The goal is to gauge how – to steal a phrase – “irrationally exuberant” investors have become. In measuring sentiment, investors should focus on two types of indicators: what are investors doing and what are they thinking.
While there are dozens of different indicators, I’ll focus on two: put/call ratios and Bullish/Bearish Sentiment. The put/call ratio is a short-hand proxy for positioning among options traders. Lower readings correlate with more bullishness. The ratio was 0.48 at the end of November 2013. While this is modestly below average, it is a far cry from the lows of early 2000. In other words, options investors are positioned bullishly, but not excessively so.
Market Realist – The previous graph shows the put-call ratio for the S&P 500 (SPY) over the past year. The put-call ratio hovered at 2.39 in August 2014. A ratio of 0.5 or lower indicates bullish investor behavior. It means that investors are purchasing more calls (options to buy) than puts (options to sell). An extremely high put-call ratio indicates bearish sentiment among investors in U.S. equity markets.
While the ratio shown covers only the S&P 500 (IVV), the analysis can extend to the Dow Jones (DIA) and Nasdaq (QQQ) indices, given the large correlation among all three indices. The ratios were extremely low before both the financial (XLF) crisis of 2008 and the technology (XLK) bubble burst of 1999.
Continue to the next part of this series to see why other sentiment indicators can point to a stock market bubble.