Pessimism piles up

The pessimism continues to pile up. That’s important because you want to make sure you don’t get caught up in it. The rule is to go with the crowd until it reaches an extreme, at which point it pays to go against the crowd. We’re starting to see extremes all over the place now. What that means is not that Greece will or won’t blow up, but that a lot of potential bad news is being priced in. When that’s the case, it doesn’t take much good news to catalyze a rally in risk assets. Think of the optimism/pessimism (or greed/fear, if you prefer) as a pile of tinder used to start a fire.

  • Optimism is like a tinder  drenched with water. It won’t start with any source weaker than a blow torch.
  • In contrast, Pessimism is like very dry tinder; it only takes a spark.

There are a variety of sentiment measures. In last Friday’s I covered the sentiment expressed in the weekly survey of the American Association of Individual Investors. This post will look at put and call options. Here’s a bare-bones primer on options.

  • Put options (puts) rise in value as a security price declines. Generally, puts are purchased either to hedge (protect against a decline in) a current position or to speculate on an asset declining.
  • Call options rise in value as a security price rises. Calls might be purchased instead of buying the underlying security. For example, one might buy call options on Cisco Systems instead of Cisco shares. Less money is put up.
  • Put and call options may be bought and sold in combination. For just one example, one might sell a call option on one security and buy a put option on the same security with the proceeds.
  • Options are like milk; they have expiration dates.
  • Option prices are, generally, more volatile than the underlying securities

As a group, investors tend to be an optimistic lot, so the normal pattern is for more call options to be bought than for put options to be bought.  Over the last few years, about 65 puts have been bought for every 100 calls bought, for a ratio of 0.65. While our tendency is to be optimistic, occasionally we go the other way. We do it when it seems like the world might end–or at least Europe–and certainly Greece. That is, we’re doing it now.

So, here’s a look at a pile of dry tinder. The ratio of puts:calls is now back to levels last seen in November 2008. What is shown below is for options on equities and ETFs; there is also a put:call ratio the includes options on indexes, but those often involve hedging activities that may be unrelated to sentiment.

Please notice the powerful rally that ensued just from the ratio moving back to normal. Notice, too, that the put:call ratio didn’t mark the ultimate bottom, only a time when investors had gotten way to pessimistic. In short, the time to be nervous is not now. For now, at least, stay the course.

The biggest source of push-back we get from clients and others regarding almost anything having to do with history–this being one example–is that this time it’s different–it’s never been like this before. How true, how true; it’s never the same. But what is always the same is people and their emotions. They’re what led Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds, to say,

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”

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