Investing

Divergence?

Over the past few months, we’ve observed a broadening of positive performance across all stocks contrary to what we experienced over the past several years where a few large cap stocks had largely driven stock index performance. Broader participation among stocks in market gains is generally considered a healthier dynamic than the alternative. From a market observer’s and participant’s view, it’s nice to see overall breadth expanding but it doesn’t necessarily mean risk is any less than it was in the previous regime when a few large cap stocks were driving the market.

Keeping your finger on the sentiment pulse is an important part of successful investing. It can provide important context in gauging how aggressive or conservative you want to be in your asset allocation and/or in putting new money to work. It also can mentally prepare you for the inevitable correction or bear market. Nobody likes to lose money but if you understand it’s a part of investing and can appreciate when it might be more probable it can possibly soften the blow to some extent.

The put/call ratio published by the Chicago Board of Options Exchange (CBOE) provides insight into speculation. The higher the ratio (more puts being purchased than calls) the more bearish the outlook. Notice the spike higher towards the end of March of last year at the height of the COVID scare in the stock market. The lower the ratio (i.e., more calls being purchased than puts) the more bullish the outlook. Based on the current reading, the ratio is near its lowest point of the past 10 years, implying speculators are at or near peak bullish expectation levels over that time period.

Contrast the put/call ratio above with the trend in the VIX (S&P 500 volatility index). While volatility has been declining since peaking at the end of March 2020, the five-year trend line is still sloping upwards, implying the trend is up still. Volatility usually increases when investors are worried about future returns. The good news is the index is below the trend line now which may be the start of or part of new trend downward.

Finally, the number of stocks above key moving average levels remains healthy, suggesting stock market breadth remains favorable. However, the number of stocks above some of the shorter-term moving averages continues to make lower highs as we get further and further away from March’s trough while the stock market has continued to make new highs. This may just be short-term noise but is still something to keep an eye on as everything has moved up so much in such a short period of time. For long-term investors, this isn’t relevant. For investors looking to put new money to work, it can provide important context for asset allocation decisions although attempting to time the market is generally a bad idea.