This Extreme Bullish Swing Predicts Big Gains for Stocks

Investing in 2023 so far has been a bit of a dance. Two steps forward, one step back...

It's hard for investors to find their footing, especially after such a brutal 2022. The benchmark S&P 500 Index fell more than 25% to its bottom last October. 

But then – two steps forward. Stocks staged a big reversal, clawing back 17% in about four months.

The uptrend looked durable. But it faltered in February... The S&P 500 has given back about 6% since then.

It takes an iron will to stay bullish in choppy markets. And no one would blame you for preferring to stay on the sidelines...

But folks, sitting out this market may be a mistake.

Bullish bets on 2023 are still piling up. In fact, one options-market indicator just tipped into a multiyear bullish extreme.

And if history is any guide, it means a great year could be ahead for stocks.

Let me explain...

Options contracts aren't like straight-up equities...

For one, each option acts as an explicit directional bet. It says how much a trader expects an asset to rise, and how fast. Each contract also has an expiration date.

Because they're forward-dated, options contracts reflect traders' attitudes about the future.

Options can be boiled down to two basic positions. Options traders can deal in "put" options, which pay off if equities fall. Or they can deal in "call" options, which pay off if equities rise.

So we can read the ratio of put options to call options as a powerful reflection of the market's mood...

When the put/call ratio is high, it means more folks are betting on a broad market decline. And when the put/call ratio is low, it means more folks are betting on growth...

As of March 7, the ratio took a swan dive. It hit its lowest level in three years. Take a look...

The put/call ratio sank from 1.13 to 0.8. That reflects a big bull rush.

I wondered what this move meant for the future... So I combed through 20 years of options market history to find other times the ratio fell this hard.

In order for a move to count, the put/call ratio had to fall by 0.33 or more in a single day. And it had to land at a level of 0.8 or lower. In other words, I was only interested in massive sweeps into bull territory.

It turns out that put/call ratio swoons like this one tend to precede a great year for stocks. Take a look...

The S&P 500 earns about 7% in an average year. But after the put/call ratio craters, stocks tend to do even better. Buying after the extreme led to average gains of 6% in six months and 12% in one year.

Looking at instances where the put/call ratio fell 0.33 points in a day and ended at 0.8 or lower gave us a robust sample size, too. We've seen this kind of move 68 times since 2003. And on 60 of those occasions, stocks were up 12 months later. That's a hit rate of nearly 90%.

So even if this indicator isn't perfect... it's promising.

Based on the put/call ratio, the bulls are undeterred after a tough February. And if history is any guide, they may still win the year after all.

Good investing,

Sean Michael Cummings

Further Reading

"Despite the market's seeming downtrend, most stocks have stopped falling," Brett Eversole writes. Most folks look at the S&P 500's movements to gauge the market's health... But in certain moments like right now, that gives you an incomplete picture. In fact, if you look below the surface, you'll see a strong sign that the bear market is over... Read more here.

"Stocks have a powerful upward bias," Brett explains. Investors forget this when a bear market takes over. But lately, that pessimism has laid the groundwork for a major contrarian opportunity... Learn more here.




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