Investors are pessimistic, but buying speculative options
Defining "sentiment" isn't a one-sided affair. All of us want to look at a single end-all, be-all indicator of what the hordes are thinking or how they're behaving, but it's just not that simple. Using one metric has been way too prone to error.
The frustrating part about this is that most of the time, at least a few measures are in conflict with each other. There are usually 2-3 times per year in each market where almost everything lines up, and defining where sentiment is can be relatively straightforward. That was mostly the case in January-February (excessive optimism) and March (excessive pessimism).
Right now, most shorter-term guides are showing a lot of optimism, some on a historic scale. On a medium- to long-term basis, it's much more mixed, and some are even showing outright pessimism, even after a historic rally.
We've looked at these conflicts many times in the past, and one of the most egregious right now is between the options market and some surveys, like AAII. As noted by Urban Carmel, the two have rarely been this much at odds.
Over the past two weeks, options traders have shown a historic level of speculation, and that has pushed the 10-day Equity-only Put/Call Ratio to its lowest level since the year 2000. At the same time, the AAII survey of individual investors shows a Bull Ratio that ranks among the lowest in the survey's history.
So who do we believe? Are investors in a speculative frenzy as indicated by the options market, or are they depressed like some survey's show?
We always place more weight on real-money indicators as opposed to surveys, because people often say one thing but do another. That's true in real life, and it's true in markets.
Let's go back to 1993 and look for every time when the put/call ratio was in the bottom 10% of its range over the past year, and so was the AAII survey.
Clearly, not a large sample size here. And making it even less useful, there wasn't any real consistency among them. Stocks pulled back after this happened in 1996 and 2000, but took off to the upside in 2017.
Let's relax the parameters to get a larger sample. The table below shows times when both indicators were in the bottom 25% of their ranges.
These conditions led to returns that are in line with what we should expect. The high optimism indicated by the put/call ratios helped to put a damper on shorter-term returns, while the low optimism indicated by the AAII survey helped lead to above-average longer-term returns. Since 2010, all but one of the signals led to short-term pullbacks and long-term gains, so recent history has confirmed this general pattern.
It's rare to see indicators like this diverge as much as they are now, but it's not unprecedented. The times that it has happened, stocks have usually responded more to put/call ratios over a period of weeks and the survey over a period of many months. That would indicate some downside risk now, but more reward over the next 6-12 months.