Brad Lamensdorf, the founder and portfolio manager of Active Alts, is a principal and co-manager of the AdvisorShares Ranger Equity Bear ETF. He previously managed a long-short investment partnership from 1998-2005 under the name Tarpon Capital Management. Earlier in his career Mr. Lamensdorf was an equity trader/market strategist for the Bass Brothers’ trading arm. He managed a short only portfolio in addition to co-managing a $1bil hedging program. He also served as in-house market strategist for the entire internal and external network of Bass Brothers money managers.
Low Put/Call Ratio is Indicating the Stock Market is in Dangerous Territory. One of the most reliable contrarian indicators of future market direction is the put/call ratio. That’s because options buyers are wrong most of the time. The present low ratio is warning us to be very careful because most investors have become so bullish. They’ve thrown caution to the wind in terms of hedging against a downturn. The ratio calculates the total number of put options that small traders bought to open versus the number of speculative call options they bought to open. The lower the ratio, the less hedging and naked speculating that they’re doing. As the chart below shows, the ratio is at its lowest level since November 2007. Prior to the financial crisis that sparked a major stock market downturn. This is one of a number of indicators we’ve highlighted in LMTR recently that is warning us the market is in a very precarious position.
I have also added the 5 day put ca.. ratio that is at a multi year low as well.
Increasing Investor Optimism Puts Stock Market in Danger Zone. We use investor stock market sentiment as historically important contrarian indicators to determine where the stock market is headed. The indicators have proved to be particularly accurate as they move closer to extreme bullish and bearish levels. This week’s Investor Intelligence survey of more than 100 editors of stock market newsletters shows bullish sentiment among the editors moving into those higher dangerous elevations, close to what occurred before the downturn earlier this year.
Bullish sentiment increased to 57.7% after a small dip to 54.5% the week before. Investor Intelligence notes that bulls above 55% mean investors should start taking defensive measures for protection against a possible downturn. Those measures include tight stops at a minimum, and possibly selling shares with big gains. In other words: Don’t be greedy! That’s inevitably a loser’s game. We should also note that bullish sentiment signals even more danger the higher it gets over 60%. And that also signals the need to prepare for a market decline. Although there’s no certainty about when the decline will occur.
Meanwhile, the market surge trimmed bearish sentiment to 18.3% from 19.8% a week ago. Bearish sentiment below 20% is not favorable for longs. The bull-bear difference expanded to +39.4% from 34.7%. That’s the widest spread since January, and another reason for being careful (See chart below).
Q Ratio Indicates Stock Market Value Historically is Overpriced. We use many indicators to analyze stock market value and future trends. One such popular indicator is the Q Ratio. It was developed by Nobel Laureate James Tobin to estimate the fair market value of the stock market for the long term. The ratio is the total price of the market divided by the replacement cost of all its companies.
As you can see from the chart below, present fair valuation is quite high at 1.79. Therefore, this suggesting the market is trading at 129% above the mean historic replacement cost, says Jill Mislinski of Advisor Perspectives. Note that the all-time Q Ratio high at the peak of the Tech Bubble was 2.17, about 180% above the historic average of replacement cost. The all-time lows in 1921, 1932 and 1982 were around 0.28, which is approximately 63% below replacement cost. Mislinski cautions this is not a short-term indicator. “Periods of over- and under-valuation can last for many years at a time,” she says. That means the Q Ratio is “ more appropriate for formulating expectations for long-term market performance”.
Companies are Raising Their Earnings Outlook: Be Careful! Spurred by pandemic fears many companies earlier this year pulled way back on their profit outlooks. In fact, many said they couldn’t make any predictions at all. In recent weeks, however, with an increase in business openings and employment, these companies, and the analysts who follow them, have become increasingly optimistic about future earnings. As the chart below shows, a great percentage of companies are raising their earnings. In fact, by some definitions companies haven’t raised their outlooks to this degree in 20 years.
So ,why are we telling you to be careful? The most obvious reason is that record daily Covid-19 infections now are forcing even the reddest states to close many businesses that had been reopened. So, the economic outlook may not be as rosy as the companies thought, despite June’s big employment growth. Equally important is that historically by the time companies have become this enthusiastic about future earnings, investors and the market already have anticipated the gains. That means the stocks and the indexes are already fully priced in anticipation of the higher earnings, And fully priced means that bad news, including lower-than expected earnings, is a setup for a big market drop. So be careful and don’t become victim to irrational actions spurred by the fear of missing out (FEMO). FEMO historically results in investors buying too high and selling too low.
Investor Sentiment on Stock Market Remains in Caution Zone. We use investor sentiment as a contrarian indicator of where the market may be headed. One of our favorite indicators is the Investor Intelligence poll of more than 100 stock market newsletters. The jump in Covid-19 cases sent the stock market lower last Friday. And that caused a small retreat for the newsletter bulls to 54.5% from 57.3% the previous week. That’s just below the 55% level which indicates investors should take defensive measures. Nevertheless, bullish sentiment certainly remains too high to indicate a big rally lies ahead. In other words, at these levels, investors should remain cautious. Bearish sentiment was up slightly to 19.8% from 18.4%, Bears below 20% historically are not favorable for longs. Another note of caution comes from the bulls/bear difference, That’s despite the fact that it moved down to +34.7% from its recent high of +38.9%. (See chart below).