Many investors are more than ready to say goodbye to 2022. The S&P 500 is on course to deliver its worst performance in 14 years. The Nasdaq Composite Index remains firmly entrenched in a bear market.
But there might be at least one reason to think that the year could end on a positive note. Could this rare indicator hint at a big rally for stocks in December?
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A rare anomaly
The put-call ratio is a metric used to determine investor sentiment. It measures the number of put options purchased on a given day against the number of call options purchased. Puts give investors the option to sell an asset at a given price by a specified time. Calls give investors the option to buy an asset at a given price by a specified time.
When the put-call ratio is below 1.0, it's viewed as a sign of investor confidence. Higher call option volumes can reflect that investors are more optimistic. However, when the put-call ratio is above 1.0, it's seen as an indicator that investors aren't very confident about the future.
It's not surprising that when stocks sink on a given day, the put-call ratio for the S&P 500 moves above 1.0. A sharp sell-off stokes investors' fears, prompting many to buy puts to hedge their positions. On the other hand, when the stock market surges, the put-call ratio often falls below 1.0 as investors rush to buy more call options.
But last week, a rare anomaly occurred. The S&P 500 jumped more than 1.3% on Nov. 22, 2022. You'd expect the put-call ratio to fall on such a move. However, it instead rose to nearly 1.4. This kind of increase in the put-call ratio on the same day that the S&P 500 moved 1% or more higher has only occurred three times since 1997, according to Fundstrat Global Advisors head of research Tom Lee.
Santa Claus (rally) is coming to town?
The surprising thing about the past three times this indicator has flashed is that stocks have gone up afterward. Lee noted that the S&P 500 delivered solid positive returns over the following three, six, and 12 months the previous times since 1997 that the put-call ratio rose above 1.0 on the same day that the S&P jumped by at least 1%.
You might have noticed that Lee didn't say that the S&P 500 jumped in the month after the rare indicator occurred. But he thinks that the major stock index could soar to 4,500 -- more than 12% -- by the end of December.
Lee's optimism stems in part from the unusual put-call ratio move last week when the S&P 500 surged. He's also encouraged by inflation slowing.
December is often a pretty good month for the stock market -- especially near the end of the month. Back in 1972, Yale Hirsch wrote in the Stock Trader's Almanac about a pattern he dubbed the Santa Claus rally. The S&P 500 frequently rises during the last five trading days in the year, with the momentum extending into the first two trading days of the new year.
The problem with indicators
Will there be a big rally for stocks in December? Maybe, but I wouldn't rely too heavily on any indicator. You can easily find other indicators that are bearish.
The problem with indicators is that they usually don't occur enough times to be statistically reliable. Investors should be especially hesitant about using indicators that don't appear to have logical connections with stock market performance.
However, there's one "indicator" that has proven itself over time. Stocks tend to go up over the long term. If you're patient enough, you'll see a big stock market rally.
