Equity Put/Call Ratio: The Domain Concept

The equity put/call ratio is one of my favorite short-term market timing tools. However, I look at the indicator a bit differently than other investors. Often, absolute boundary values are defined in order to determine if sentiment is too bullish or too bearish. For example: when the 20 day moving average of the ratio records higher than 0.7, a "buy" signal is generated. To be honest, I argued the same way in recent post. However, it is important to look at the longer term picture.

I'm stating the obvious here, but in general, investors are more bullish in a bull market and more bearish in a bear market. You can actually quantify this notion by looking at put/call ratios on a longer time scale:

 

The put/call ratio seems to oscillate in more or less constant domains for a certain period of time.

Note how the domain boundaries (0.5;0.7) worked perfectly during the recent bull market.  During the financial crisis however, the levels came in at (0.7;0.9). So whatever was considered overly optimistic during the crisis, had been a overly pessimistic reading during the current bull market. Before 2008, the levels were (0.6;0.75).

It is challenging to determine when markets are about to transition from one to another domain, which they obviously have to do from time to time. Ignoring the possibility of a transition process would totally kill investment performance, because investors would go long when they should be short. Predicting domain change might not be possible, but being aware of the effect can help manage risk.

Are market's in a domain change process right now? They might be. Applying simple technical analysis to the 20 day moving average of the put/call ratio can help to answer the question.