Are consistently low put/call ratio’s bad for the stock market?

In recent days, the consistently low equities only put/call ratios, ($CPCE) have received some attention (see for example here and here) including by my self (see here).  Based on the first two links I wanted to test the hypothesis of “are consistently low $CPCE readings good or bad for the market?” myself and instead of a 21-day Simple Moving Average (SMA); I used the 21-day Exponential Moving Averages (EMA), which place more weight to the most recent reading compared to the SMA. In addition, those two sources looked at 5 years and 2.5 years back in time; respectively, whereas the $CPCE has been around since late-2003: almost 14 years of data. Hence I wanted to extent their already great work even further to be as complete as possible because, for example, the past 5 years may have been different than the prior 10 years as market environments may have changed.

Regardless, I want to thank both authors for their inspiration!

The thesis is that when the 21d EMA of the $CPCE drops below 0.62 there may be head winds for the market. The chart below tells the story since late-2003. The green dotted vertical lines show the approximate center of when readings bottomed out <0.625 and the dotted red vertical lines show when it bottomed out even lower: below 0.525. Yes, this means that the longer term trend for the $CPCE can go much below 0.625. Thus this already tells us that just because the 21d EMA of the $CPCE is below 0.625 doesn’t necessarily and directly mean it’s bad for the market.

CPCE 21d EMA

Please note, not all occasion of <0.625 are marked as there are many incidences where such low readings only coincided with very temporary tops in periods of a strong up trending market; as well as to avoid clutter. Those periods are highlighted with the red boxes: the 21d EMA was consistently below 0.625 sometimes even as low 0.525. This also adds to the notion that readings below 0.625 or even below 0.525 are not necessarily bad for the market; e.g. signs of a pending bear market.

Instead, low readings sometimes mark larger correction, but most often mark shorter term tops, which -and make no mistake- are certainly very trade-able tops. But, before making final conclusions, let’s first look in more detail over the past 3 years. See chart  below.

SPX 1min-detail2

Since we’re dealing with a moving average, the readings can -as said- remain well-below 0.625 for quite some time. The readings in June and July of this year show that the actual days when the 21d EMA moved below 0.625 don’t really mark “the top” in the equities market. Instead it takes a while (days to weeks), and often only marginal higher highs are made in a choppy fashion. The latter is consistent with an Elliot Wave pattern of final 4th and 5th waves being completed.  Last Friday the 21d EMA dropped below 0.625 and today the S&P500 registered it’s first >10p drop in 7 days. Hence, so far so good.

In addition, the green and red arrows show there are longer term trends within the 21d EMA. The red arrows show how it is slowly trending up (more and more puts are being bought), which is in general eventually bad for the market as the trend often culminates in bigger corrections in the equities market (2008, 2011, 2015/16). The green arrows show the 21d EMA is trending down (more and more calls are being bought), which in general is good for the market as new Bull markets start and continue that way. Currently the trend of the 21d EMA is essentially flat, which suggests the recent uptrend in put/call ratios may be reversing. However, as said, it will take some time before the market catches on.

Considering my preferred view is that of the market currently wrapping up it’s final waves for major-3 of Primary V, possible one degree low: intermediate-iii of major-5 of Primary III, I do expect the current low 21d EMA $CPCE readings to be a tell tale of a pending larger correction.

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