The easiest way to succeed on the stock exchanges is to buy and hold the index. You don’t need to create portfolios or think about which stocks to invest in. Just buy and hold the index. There has been a long bias on the stock market with an average yearly return of 9.8% (non-inflation-adjusted) for the last 100 years (Composite Index, predecessor of S&P 500). From 2010 to 2020, beating leading US indices with your own portfolios was tough. But this decade may be different. For the investor, the most important thing is to buy low and sell high in the long term. Well, we never know if we are on the top or bottom. Let’s talk a little bit about the timing.
The best entry timing is straight after the drawdowns. You can set some basic rules if the market falls more than 5% in a short time and there is no major fundamental reason for the bear market, you can buy. By fundamental reasons, I mean the problematic mortgage market in 2008 before the crisis or the beginnings of covid-19 pandemics in 2020. If some big event affects the market for a longer time, that is the best investment opportunity. The best time for long-term investments is when there is absolute despair in the market. But that is kinda risky, too. You don’t know if, after the mayor drops, the market will not fall another 15% or 30%. And you don’t want to go to the drawdown straight after the investment. One of the answers is cost averaging.
Timing the exit really depends on your objective. Suppose you are using some news or new fundamental information. In that case, you should have some profit target and time horizon of your investment and the way out if something bad happens. The way out could be something like when the first panic sale started when covid-19 started to spread in Europe quickly, and we all already knew what happened in China. The first quick selloff came on 24th Feb with an overnight drop, and we were only 5% down from our high on S&P 500. But if you are not watching the markets daily, it is possible you missed that. Later, when stocks dropped another 5%, it was already clear that the world was on its way to lockdowns.
Usually, when you invest in growing and protecting your capital, you react only to extreme situations like a crisis because only that has the potential to wipe out your grown capital for years. If there are some corrections, most of the time, you use them to increase your investment.
The idea is simple - imagine you were waiting for a major event and have prepared 100k USD to invest. Instead of investing all in one moment, spread your investment into 3 to 10 consequent buys and buy once a week or a month, depending on the fundamental event and your opinion on how long it could last. The final buy price will be averaged over time. In some cases, you possibly caught the bottom, and others, not. The major stock drops like the dot-com bubble and the financial crisis of 2008 are great examples of cost-averaging. The stock crash of 2020 and the subsequent recovery were so fast that you could not make more buys while the prices were lower. You just have to set some basic rules, like wait until the market crashes 30-40%. When seeing some recovery, you can start with cost-averaging (you don’t know if it will continue falling more at that point).
This was my tactic for the 2020 crash, but as we know, it was super fast, and all the other purchases were more costly than the first one. The stock market is dynamic, and we never know when there will be a significant trend change, and it is also possible that after the major drop, the market will continue falling for a few subsequent years. There are many examples in history. Look at the S&P 500 historical plot at the beginning of this chapter. If we talk about 100 years interval, there were dozens of crises or market corrections.
Example of the cost-average
Let’s look at an example of the cost average during the financial crisis of 2008. This is only for example purposes. All of us are biased when analyzing this situation. Let’s invest in the NASDAQ 100 ETF, QQQ. Honestly we couldn’t know when the selloff finished, so let’s consider a 40% drop and subsequent bounce from the bottom as the starting point for some investors. From that date, we will have random investors who start randomly within 2 weeks difference from each other. Each investor will do 10 subsequent buys and buy at random times every 1-3 weeks. The first risk-seeking investors started in Nov 2008, and the most risk-averse investors began at the end of Mar 2009, when on Nasdaq 100, we confirmed the growth.
The overall mean value from Nov 2008 until Jun 2009 was around price 31. The first risk-seeking investors gained the best cost-averaged prices, around price 29. That is a 7% better entry price but still 11% worse than the bottom price of 26. As we said, getting the bottom price is almost impossible. This example is very hypothetical because, in the situation of total despair in the first quarter of 2009, it is questionable if you would enter the market. This was an example on NASDAQ 100, and if we look at the graph of the S&P 500, we can see that during Mar 2009, there was really total fear that the bottom was still far away!
Just ask yourself, would you really buy during Feb and Mar 2009? When it looked, we were getting new bottoms very quickly. The first risk-seeking investors would get the price of 87, while almost the same price will get the last investors during Apr and May 2009. The best price would get investors who started Jan and Feb 2009, around 80. The overall average was about 84.
There is a legitimate question if this is not too optimistic a view. Because of the despair at the beginning of 2009, it is possible that most of these risk-seeking investors would start in May 2009. The investors who cost-averaged at the end of 2008 for 87 USD would first see their portfolio drop another 20% to begin the growth. But still, for a long time buy, they got it for an excellent price.
Let’s look at an exciting methodology some professionals use to get a better price.
Searching for bottoms: Put/Call Ratio
The put/call ratio represents another type of market sentiment. It is calculated from volumes on the options market. The option is like insurance – a call option is a contract where you can buy an asset for the predefined price (strike) during an agreed time or at the contract's expiration. A put option is a contract that allows you to sell an asset for strike price during a period or at the contract's expiration. With these contracts, you can hedge your portfolio, do some speculations or trade the volatility of an asset. Thanks to the complex pricing of the options contracts, these prices aren't affected only by the underlying asset's price but also by its volatility, time to expiration, and interest rates. The volatility can affect the options price more aggressively than the underlying price.
Since options expire in the future, their price is affected by the expected volatility called implied volatility, described in stock metrics. By simply analyzing the volumes of put and call options, you can have a broader view of the market and the sentiment of the fear. With more turbulent times, investors tend to buy more put contracts to hedge their long positions in case of substantial price drops. When the put/call ratio is greater than one, more puts are bought, so investors are feared. Oppositely, when the ratio is lower than one, many more call options are bought. Analyzing the peak in this ratio can have a predictive value if we are at a peak or at the bottom of the asset price.
The put/call ratio and S&P 500 ETF
The figure shows the price of the S&P 500 ETF, SPY, with prices on the left axis. The gray and red lines represent the put/call ratio, and values are on the right axis. We use daily data publicly available on CBOE web pages, and we calculate 5 days moving average of the ratio to make the line more smooth. Daily changes in the ratio are just too extreme. We use the volume of all option contracts on the market (not only the index options). Index S&P 500 is the most representative index of the US market. It consists of the most traded symbols weighted by market capitalization. These stocks also have a higher trading volume in the options market, so this comparison is correct and representative. With higher values of put/call ratio, we see bigger drawdowns on SPY, and with peaks, in the ratio, there are bottoms on the SPY. Is there any predictive value?
We simply analyze index returns for higher and lower put/call ratios represented by a 5-day moving average. Higher values are higher than the 90th percentile of the last 100 trading days, and lower values are below the 10th percentile. Normal values are between the percentiles. The table compares returns after the put/call ratio value was observed. We also compre the returns calculated with 3 and 10-day time lag after observing extreme put/call values. Simply because we need some time after the top/bottom to recognize there was a top/bottom. So the tops of put/call can show the bottoms and tops of the asset price. In this study, we use daily data from Jan 1995 up to Aug 2022.
We can see that returns after observing high put/call values are significantly greater than other values in the table. Three-month returns are higher than 3% after an extremely high put/call ratio, while for normal ratios, they are around 2% and for lower ratios are only around 1%. All values were tested against normal values, and returns after an extremely high ratio are significantly greater than during the normal ratios. Similarly, returns after extremely low ratios are significantly smaller than normal values. This is an interesting observation and proves that the put/call ratio has a predictive value. The longer history we look to, the greater the difference.
These extreme values can indicate when to enter a position (high ratio) or when to not enter a long-term position n (low ratio). Even better, let’s look at the crisis 2008 and covid-19 selloff and distinguish put/call ratio peaks as entry points. To distinguish peaks, we have to wait until the confirmation of the peak, which can take a few days. We can’t invest directly when the potential peak is observed but a few days after (let’s be strict and set it to 15 days). We invest only in a ratio above 1. The next two figures are SPY prices with put/call ratio and its moving average. The red inverted triangle is a peak confirmed within +- 15 days, and the small green triangle is the price of SPY when the peak on the ratio occurred. Finally, big lime triangles are 15 days after the peak was observed and only if the value of the moving average was greater than one.
The put/call ratio with buy opportunities during the financial crisis 2008.
As you can see, analyzing the put/call ratio may add more information to your decision process. The problem during crises like 2008 is that there were several peaks. At the time of one peak, we didn’t know how many other peaks there would be in the next few months, so the investment could not be spread uniformly as with the cost-average. In 2020 (next plot) the real bottom was more than a week after the peak in the ratio. 15 days after the peak in the ratio was a sufficient time to distinguish either local bottom on SPY and top on the ratio. This led us to invest in the first days of April 2020 as a perfect buy. Of course, if there were no huge fiscal and monetary stimulus, we may only bet how low the prices could have dropped.
The put/call ratio with buy opportunities during covid-19 selloff.