Increasing optimism is dangerous for key stock indices. Sadly, this is exactly what we’re seeing in the markets right now. It is very evident wherever you look. Stock advisors are saying, “Just buy stocks, and you will do alright.” Investors feel good about stocks. Those who were bearish on the key stock indices since the crash in 2008 and 2009 are also turning bullish—the bears are declining in numbers each week; it’s becoming especially difficult for them to keep their pessimistic stance these days.
One of the key economic indicators that I follow when looking at the optimism in key stock indices is called the Chicago Board Options Exchange (CBOE) total options put/call ratio.
This indicator, at the very core, shows the ratio of volume of puts and call options. When there are more call options, this ratio stands below one. When there are more put options than call options, the ratio stays above one. Currently, this ratio stands at 0.6—a level last seen in 2011. Since at least 2007, this ratio of call options to put options has reached this level only a handful of times, as you can see in the chart below.
Chart courtesy of www.StockCharts.com
When call options increase, it means investors are bullish towards the key stock indices. When the put options increase, it means investors believe the key stock indices will experience pressures ahead. The current put/call ratio suggests investors are not worried.
Another indicator I look at to assess the optimism on key stock indices is margin debt—the amount of stock purchased on borrowed money. When margin debt is high, this shows that investors are willing to invest in stocks and risk borrowed money that they eventually have to return, meaning they’re very optimistic. In November of 2013, the margin debt on the New York Stock Exchange (NYSE) hit an all-time high. It stood at $423.7 billion—a more than 16% increase since January of 2013, when it was $364.1 billion. (Source: “NYSEData.com Factbook: Securities Market Credit ($ in mils.),” NYSE Technologies web site, last accessed January 13, 2014.)
Margin debt—or leverage—at the end of the day, turns a small downtick in key stock indices into a massive market sell-off. As the stock prices go down, investors’ losses get massive, so investors panic and run for the exit door. In 2007, margin debt on the NYSE reached an all-time high; a few months down the road, key stock indices made a top. A massive sell-off followed in 2008.
Is what we are seeing now an indicator of a top in key stock indices?
As I have mentioned many times in these pages, it can be very hazardous for investors to predict tops and bottoms. It can have a significant impact on their portfolio—possibly facing massive losses if their predictions don’t come true. Instead of predicting where the top will fall in place or if the top has already been placed in key stock indices, investors should simply just be cautious. If the key stock indices do turn, investors may be able to profit through exchange-traded funds (ETFs), like ProShares Short S&P500 (NYSEArca/SH). This ETF essentially provides investors gains as the S&P 500 falls.