Risk Ratio Indicates More Correction Coming

Courtesy of Doug Short.

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The current market correction should not come as a surprise to any one. There has been consistent and substantial evidence that the rally that began last October was unsustainable. We discussed the coming correction beginning in March (see here, here, here and here). The question now is whether the current correction is over … or is there more to come?

It fascinates me to watch the media during market rallies as the bullish sentiment takes hold. Investors are never told that the risks of investing are rising and some caution should be taken. It is “always” a time to buy and never a time to sell. However, this is absolutely contrary to the basic premise of investing which is to “buy low and sell high.” Therefore, as investors, we are left on our own to determine when it is “…a time to reap and a time to sow.” Whether you are a trader, or a long-term investor, the idea of portfolio management is the same. A portfolio, like a garden, will prosper only when it is cared for by weeding (selling losers), watering (making consistent contributions) and pruning (taking profits). A well-tended garden will produce bountiful harvests while an untended garden will eventually succumb to the weeds.

Bob Farrell’s rule #9 is: “When all experts and forecasts agree ? something else is going to happen.” This statement encapsulates the basic tenant of being a contrarian investor. As Sam Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?”

Going against the herd, as Farrell repeatedly suggests, can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is the darkest. However, being a seller in exuberant markets or a buyer in a major rout is very tough, if not impossible, for almost every investor, because the emotions of “greed” and “fear” overtake logical buy and sell decision making.

In order to measure the “greed” and “fear” syndrome, I have taken some of the most common measures of investor sentiment (the volatility index, new highs versus new lows, two different polls on bullish versus bearish sentiment, and the rate of change of the S&P 500 index) and used weekly data to combine them into a single “risk ratio.” The reason I used weekly data rather than daily data was to smooth out the day-to-day volatility of the markets to focus on trend changes in the market. The risk ratio functions as an oscillator — rising as investors become more bullish and vice versa. What is important to notice is that the sentiment ratio generally starts turning down before the market actually peaks. This ratio has been a key driver of recent commentary warning about the coming correction.

If we lay out the “risk ratio” in bands we can more clearly see what actions need to be taken after various points during the oscillation cycle. With the oscillator in the upper band and turning down it has clearly been a sign to reduce overall portfolio risk. While the market is clearly oversold on a short term basis, and very overdue for a bounce, the risk ratio dictates that the bounce should be sold into as the longer term correction is most likely not completed as of yet. Generally, the best buying opportunities have occurred when the risk ratio has gone from “bullish alert” or “extreme bullish” to the opposite extreme. Most importantly, it is critical to note that the buying opportunity does not come until there is a turn up in the ratio from the previous decline.

The current down turn in the risk ratio signifies that the current correction is still in progress and will likely continue for at least several more weeks. However, as I stated above, the market is currently extremely oversold on a short term basis and will likely have a very strong counter trend rally to work off the daily oversold condition. The current market is acting very similar to what we saw in 2011 as a potential debt ceiling debate and Eurocrisis loom. This opens the door to further weakness in the weeks to come.

The one aspect that cannot currently be accounted for, which could quickly reverse this analysis, is the introduction of additional stimulative programs by the Fed. While I currently have little doubt that we will see further easing programs – I do not think that they will come about until we see further economic weakness and a more substantial market decline which would give the Fed the “permission” it needs to take action.

Reiteration Of What To Do Now

As we discussed in yesterday’s article “Confirmed Sell Signal Approaches” we stated: “We will want to sell into any reversal that takes us back to previous support levels that have now turned into resistance. Currently, those levels will be 1350, 1360 and 1375ish. Do not get hung up on specific numbers – these are general areas where you want to start raising cash. If the markets are able to rally above those levels we will update our commentary at that time.

The recommended course of actions are:

1. Liquidate weak and underperforming positions as the market approaches the 1350 and 1360 levels.
2. Rebalance winning positions by taking profits and resizing positions back to original weights at the 1350 and 1360 levels respectively.
3. Look for rotation into precious metals as a “safe haven” investment which is currently very oversold.
4. Short duration fixed income is still an alternative as rates will likely remain under pressure from the rotation out of stocks.
5. Be careful with dividend yielding stocks ? while they will likely hold up during a correction they are already overbought in many cases.
6. Our call to buy bonds over the past month has played out well. They are currently overbought and extended. Hold current positions but be selective on new additions at this time. Wait for a move in interest rates to 2.2% on the 10-year treasury before aggressively adding more.
7. Hold cash for a buying opportunity when the next “buy” signal becomes apparent.”

Remember, it is the psychology of market participants that ultimately drives prices higher and lower as they respond to the external stimuli of the economic, fundamental or political landscape. This is the value of the “risk ratio” indicator in measuring those “fear” and “greed” factors.

The most important asset destroyed by reversion processes is “time.” It is the one commodity that you have a very limited supply of and no ability to replace. By using tools to measure, analyze and understand the environment that we face today and will continue to face in the future, we can make better decisions in both our planning and investment process. The management of the many inherent investment risks is critical to long-term survival. For individuals it is important to recognize that the“return of capital” is always far more important that the“return on capital”.