Investors often pay attention to tactical indicators such as VIX (CBOE Volatility Index), AAII (American Association of Individual Investors) Sentiment Survey Bull-Bear Spread and CBOE Put/Call Ratio for insights on stock market greed and fear behaviour to time possible entries and exits.

This report looks at the relationship between each of these indicators and the S&P 500, to find out if they can be lead indicators for market direction.

CBOE Equity Put/Call Ratio

CBOE’s equity put/call ratio looks at equity options. A high put/call ratio suggests that the market is overly bearish and stocks might rebound. Conversely, a low put/call ratio suggests that market exuberance could result in a retracement.

Looking at the chart (Figure 1), it has been a useful indicator to predict a market rebound when the ratio goes above the 0.8 level. Notably on the past three occurences in 2019, 2020 and 2022, the S&P 500 produced a V-shape rebound. It has been less reliable to predict a market reversal from the peak at the other extreme level of below 0.60 as it produced many false signals in 2021.

Thus, the put/call ratio serves as a good indicator to estimate market rebounds when the ratio hits extreme levels of bearishness but it does not function well to predict short-term peaks in the market especially during a strong bull market. One drawback to note however is that it is a poor timing signal and serves more as a coincidental indicator which moves together with the market.

AAII Sentiment Survey Bull-Bear Spread

The AAII Sentiment Survey offers insight into the opinions of individual investors by asking them their thoughts each week on where the market is heading in the next six months – up (bullish), no change (neutral) or down (bearish). Tracking sentiment gives investors a forward-looking perspective of the market instead of relying on historical data, which tends to result in hindsight bias. The bull-bear spread is calculated by subtracting the percentage of bearish surveyees from that of bullish surveyees.

Looking at the chart (Figure 2), it does not serve as a good indicator to predict short-term market peaks at the 20-40% zone as there have been several occurences where the S&P 500 continued to rally in the following months when surveyees were more bullish than average, in 2014, 2016 and 2020. It performed better to gauge short-term rebounds below the -20% level where the S&P 500 tended to produce a V-shape bounce in 2016, 2018, 2019, 2020 and 2022.

Thus, the effectiveness of the AAII bull-bear spread is similar to the CBOE put/call ratio which is more useful to predict market rebounds than market peaks. Some limitations include that it also serves more as a coincidental indicator which moves together with the market and the reliability of survey results is more opinion-based and does not affect the market directly in fund flows unlike the CBOE put/call ratio which is calculated based on actual put and call options purchased by investors.

CBOE Volatility Index

The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the US market, derived from real-time, mid-quote prices of S&P 500 index call and put options. It is one of the most popular and recognized measures of volatility.

Looking at the chart (Figure 3), it functioned well to predict market rebounds during periods of higher volatility above the 30 level, in 2015, 2020 and 2022. It had less utility to predict market peaks as there have been many instances when the S&P 500 continued to rally in the mid term even during periods of low volatility when VIX was below the 15 level throughout the past decade, including the market performance we are observing this year.

Thus, the effectiveness of the VIX is similar to the 2 tactical indicators, CBOE put/call ratio and AAII bull-bear spread mentioned earlier. A limitation of it is during periods of high volatility, when the VIX could surge well above the 30 level like in 2020 when it was above 50 before the market rebounded. It cannot be used to time a short-term market bottom accurately all the time.

Conclusion

Tactical indicators such as the CBOE total put/call ratio, AAII Sentiment Survey Bull-Bear Spread and CBOE VIX are some popular measures investors refer to gauge greed and fear levels in the market. They are similar in being more useful to estimate market rebounds than market peaks. However, that also comes with the limitation of not being able to act as leading indicators as they move together with the market.

The preferred tool to look at for estimating market rebounds appears to be the CBOE total put/call ratio as the extreme level of above 0.80 has been consistent with market rebounds even during periods of high volatility and extreme fear such as the 2020 Covid market crash.