The frothier elements of global equity markets ‒ mainly technology and emerging markets stocks ‒ will probably enter a period of consolidation in December.
While the medium-term outlook remains solid, there is also a feeling that “all the good news” is probably discounted in the short-term, as even unlikely positive surprises such as an imminent tax cut in the US and an agreement over Brexit between the UK and the European Union appear within reach.
The S&P 500 failed to move through an important technical resistance at 2,650 points. This probably heralds a short-term period of correction during which investors should accumulate stocks on weakness.
This week, we expanded our toolbox of sentiment indicators by looking at figures about outstanding put and call options on major stock market indices. Most investors are familiar with put/call ratios which compare the volumes of put and call options traded on a given market instrument at a point in time.
We discovered that the open interest of call and put options — i.e. the total number of outstanding put and call options on a stock market index — contains useful information about the degree of enthusiasm which underpins equity markets. The ratio of total outstanding put over total outstanding call options tends to oscillate in a synchronized way with major stock indices.
We surmise as rationale that professional investors hedge some of their gains by buying additional put options after a protracted upswing in equity prices. When the put/call open interest ratio soars over long periods of time to stretched levels, it tends to adjust back, triggering either a period of consolidation or a market correction.
Such an adjustment caused medium-sized corrections of the S&P 500 index in 2014 and 2015. Investors drastically cut back their put positions after a mild correction from September to November 2016, quickly followed by the election of Donald Trump. The ratio between the open interests of put and call options on the S&P 500 once again spiked in September 2017 and was fully ignored by a strong bull market.
The put/call open interest ratio for the Nasdaq 100 went through the roof in October-November 2017. This extreme demand for put options seems to coincide fairly well with the weakness, which started in large technology stocks at the end of November.
On a similar note, the same indicator for the MSCI Emerging Markets ETF spiked in September and tumbled afterwards. This shift in option demand preceded a short-term top by late November in the MSCI Emerging Markets index, where more short-term weakness seems likely.
For the sake of clarity, we reiterate our positive medium-term views on technology and EM equities. Our work on the ratios of outstanding put and call ratios adds value as a timing indicator, is not however intended to replace a more fundamental assessment based on macro and liquidity indicators.
We conducted the same analysis for European and Japanese stock market indices. The Euro Stoxx 50 and the German DAX do not reveal significant shifts in option market sentiment and we anticipate continental European equities to trade sideways for a while longer.
We conversely witnessed a steep increase in our put/call open interest ratio on the Swiss Market index (SMI), suggesting that a period of consolidation is needed before Swiss equities can reassert their uptrend.
The trend for the Japanese stock market reveals little hedging demand, probably showing that investors feel confident with the persistence of recent gains in the Nikkei 225.
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