It was a difficult holiday for the markets in December.
As if 2022 wasn’t already painful enough for stock investors, December saw the S&P 500 drop 5.9% to finish the year down 19.4% – the worst calendar year return since 2008.
But in 2023, there’s good news amongst the gloom.
That’s because investor pessimism is reaching extreme levels… And that could mark a turning point for the stock market – at least over the short term.
Here’s why you should be paying attention to investor sentiment…
The Mood of the Crowd
Sentiment measures investor feelings toward the stock market.
It works as a contrarian indicator. That means it pays to go against the mood of the crowd.
After all, it was Warren Buffett that said, “be fearful when others are greedy, and greedy when others are fearful.”
The easiest way to measure fear and greed is to simply survey investors about their feelings on the stock market.
One popular survey comes from the American Association of Individual Investors (AAII). Their recent poll shows that bearishness among investors at the end of December is the highest since mid-October… back when the S&P 500 started a 10% rally.
But there are other ways of measuring sentiment.
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Time to Be Greedy?
In addition to asking investors how they feel, you can track sentiment with actual portfolio bets where there’s money on the line.
And there’s one area flashing fear levels never seen before… the ratio of put option volume relative to call option volume.
Buying a call option allows you to benefit from upside in stock prices, while put options gain in value when a stock price drops.
So, it’s possible to measure investor sentiment through the ratio of puts traded relative to calls.
When many calls are purchased compared to puts, it’s a sign that greed is the emotion in control.
But when there’s a surge in put option volume relative to calls, that means investors are fearful of downside. As a result, they’re purchasing puts to either profit from falling prices or hedge their portfolio.
And remember, these signals work as contrarian indicators – particularly at extreme levels.
That’s why the holiday action in the CBOE put/call ratio has my attention.
The ratio jumped to 2.4 in last week’s trading. That’s the highest level ever and shows extreme fear in the markets.
You can see that in the chart below, which shows the S&P 500 in the top panel (black line) and the put/call ratio in the bottom panel (blue line).
Take a look…
Along with signs that the stock market is becoming oversold after December’s drop – overly bearish sentiment is another factor that could support a rally to start the year.
But that doesn’t mean the bear market is over…
My colleague Jeff Clark recently highlighted the ominous sign coming from the bond market, and why the first half of 2023 will likely stay turbulent for the stock market.
But as Jeff noted, that also creates tremendous opportunities… which is why you should stay tactical to take advantage of the stock market’s ongoing volatility.
Best regards,
Clint Brewer
Analyst, Market Minute
Reader Mailbag
In today’s mailbag, readers share their thoughts on Jeff’s advice to “not look back” on past trades…
Good article. The New Testament also says… “A man who looks back, is not fit for the plow.” Yes, I’ve done this and destroyed the crops ahead of me. Lesson learned!
– Gerald G.
For the “don’t look back” article, great article and advice!
– Ron S.
I’ve benefited from “looking back” in the context of recording the parameters of a trade and my decision process for making it, whether the trade succeeded or not, and that has kept me in line with my trade plan.
By logging the details of my “winners” and “losers,” I’ve uncovered certain patterns to my choices and have found that most of my losers are the trades where I veered from my plan and let emotions fog my judgment.
For me, “looking back” in a disciplined and structured manner has been a lynchpin ton sound risk management.
– Gary M.
Thank you, as always, for your thoughtful comments. We look forward to reading them every day. Keep them coming at [email protected].