By Lawrence G. McMillan
(Barron's) - This bull market is rather unpopular—and that's good.
Since the rally began in early June, most investors and traders have doubted the advance because they were so afraid of Europe's debt crisis, U.S. economic problems, and even the U.S. presidential election.
Yet option and futures trading suggested in early June that stocks would rally because investors were overly negative. Even now, this negativity persists—though not at the same extreme—which indicates the rally has at least several more months of life.
The equity-only put-call ratio—the daily sum of all puts traded on all stocks divided by the sum of the all calls traded on all stocks on the same day—is a reliable indicator. (The ratio is printed each week with this column.) When the ratio peaks and begins to fall, that is usually a good time to buy stocks. The chart on this page shows two peaks, this past June and August 2011, when bearish put volume was extremely heavy, compared with bullish call volume. Both were excellent times to buy stocks. The ratio has fallen since June's peak. This means that bullish call buying is beginning to dominate bearish put buying. As long as the ratio doesn't change to reveal a rising trend, the call-buying extreme hasn't been reached.
THE TOTAL PUT-CALL RATIO also helps investors analyze investor sentiment. The ratio's 21-day moving average rarely rises above 0.90. Mostly, far more calls trade than puts. But when puts exceeds calls, and then peaks, it sends a buy signal for stocks.
Such a buy signal was telegraphed in the second week of June—and it remains in force. In fact, it was only this week that the 21-day moving average of the total put-call ratio fell below 0.90. In other words, total put buying remains rampant despite the rally. It only now has moved out of what is considered "oversold" territory for stocks.
Finally, another important part of the sentiment puzzle are prices of futures on the Chicago Board Options Exchange's Volatility Index, or VIX. Everyone talks about spot VIX, recently around 16, but VIX futures tell the real story. VIX futures, compared with spot VIX, are extremely expensive, even though it is common to hear people say the VIX is so low that it indicates investors are complacent and perhaps suggests a short-term market correction is imminent.
However, it's not possible to trade the VIX that everyone quotes. To understand what traders think about volatility, you must examine the prices of VIX derivatives. Now, traders are paying far in excess of spot VIX levels for VIX futures that expire in coming months. For example, spot VIX is near 15, but February 2013 VIX futures are at 26. It's further evidence that this stock market rally has few believers.
Much of this VIX futures buying is a direct result of the heavy demand for VIX exchange-traded notes, primarily the iPath S&P 500 VIX Short Term Futures, or VXX. Exchange-traded note managers buy VIX futures when new VXX shares are created, and then those VIX futures are rolled forward each day.
Heavy investor demand for VXX creates heavy demand for VIX futures. This, in turn, sharply boosts VIX future prices, telegraphing another contrary indicator. When fund managers decide that they need massive volatility protection for their stock portfolios, it is, by contrary analysis, bullish.
When the investing and trading public start believing in this rally, the put-call ratios will start to reverse and the term structure of the VIX futures will flatten. Only then will it be time to sell stocks. Until then, the market—hated as it may be—can continue to march upward against this tide of negativity.
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