A reversal in sentiment suggests emerging markets can revert higher

Key points:

• Emerging markets put volume increased relative to call volume
• The EEM put/call ratio has now reversed lower from an elevated level
• Emerging markets have rallied 75% of the time after other signals

The put-call ratio as a contrary sentiment indicator

When investors are bullish on stocks, they buy call options to bet on rising prices. Conversely, when they are bearish on stocks, they purchase put options to bet on declining stocks. The put/call ratio can be used as a contrary indicator to identify an environment where sentiment has become too pessimistic on the future direction of stocks. When opinions become too bearish, stocks tend to rally.

A trading model that identifies a reversal in the put/call ratio

The put/call ratio trading model applies an 84-day range rank to a 4-day moving average of the EEM put/call ratio. The pessimistic reset condition is confirmed when the range rank indicator crosses the 99th percentile. A new buy signal occurs when the range rank crosses below the 56th percentile. Within 5 days of the cross, the 5-day rate of change for the EEM ETF must be >= 1.5%. i.e., market momentum is positive.

Similar reversals in the put/call ratio have preceded gains 75% of the time

This signal has triggered 32 other times over the past 16 years. After the others, EEM future returns, win rates, and z-scores look solid in the 2 & 3-month time frames. The 2-month window shows only a handful of painful drawdowns. With emerging markets ETF down a little over 28% on a peak-to-trough basis, an opportunity for a mean reversion trade exists. However, we need to remember that EM is in a bear market. So, we don't want to overstay our welcome.

What the research tells us...

When put volume increases relative to call volume, traders have become too pessimistic on the outlook for a given market. Stocks or ETFs are likely to reverse higher when the pessimistic extreme reverses. Similar setups to what we're seeing now have preceded rising prices for the emerging markets ETF (EEM), with a 2-month win rate of 75%. There are several indexes and sectors around the globe with significant drawdowns, especially when compared to the S&P 500. Emerging markets could be an opportunistic trade if you're looking for another beaten-down group that can revert higher.