The bears have control of Wall Street and have mauled stocks for the past five months. Now with bearish sentiment running amok is it time to begin investing back into the market for “longer term” investors? Lately there have been numerous analysts and media outlets touting the cheapness of the markets based on forward earnings expectations. The problem with that premise is that it is highly likely that those expectations are too lofty considering the economic slowdown currently in progress. Furthermore, valuation models are horrible “timing” indicators for both traders and investors. Many long term investors have been caught in “value traps” thinking a particular investment was cheap but only to watch it get dramatically cheaper. This is a lesson that can be learned from Bruce Berkowitz of the Fairholm Fund who is struggling with BankAmerica (BAC) this year.
There are better ways. At the end of April we recommended raising cash and fixed income in order to protect our investment capital. This move also gave us the capability to be buyers at the right time in the future. So how did we know to make that move?
If you take a look at our first chart, sans commentary, an individual could make the case that with bullish sentiment so low that historically now is that time to start buying. That would have been wrong. The reason was that there was a force at play then, and now, that warrants caution. The onset of a recession. During recessionary bouts bullish sentiment tends to remain mired at lower levels while stock prices are under pressure. With earnings estimates still high for the rest of this year and next; there is a high likelihood that the current economic weakness will cause those estimates to be revised downward. Furthermore, should corporate earnings actually disappoint at the same time as estimates are revised lower; then equity prices could take a fairly substantial hit. All of a sudden forward earnings based valuations are not so cheap anymore.
However, there are other measures of market sentiment that should be considered as well. While bullish and bearish sentiment are certainly important as contrarian indicators, market volatility, the rate of change of the index and new highs versus new lows all give clues as to the internal health of the market itself. One mistake that the media and many analysts continue to make is that they look at one piece of data to try and make a prediction on future outcomes. This is very difficult to do. A good prognosis comes from looking at a variety of different symptoms or indications and combining them together in order to establish a more accurate diagnosis. This is why we create composite indicators to help us create more accurate assumptions of potential future market action. The STA Risk Ratio Indicator is a compilation of the individual indicators discussed above in a weighted and smoothed index to give us an overall view of market sentiment or “health”.
The last time we published this indicator was back at the end of July when we stated: “Back in April when we first published this indicator to the public we addressed that it was time to remove money from risk assets and overweight cash and fixed income. This has provided a good hedge for the summer volatility up to this point. Now, the markets are beginning to show enough weakness to begin hitting our radar for a potential buying opportunity within the next couple of months provided some crisis doesn’t assert itself and push the markets into panic mode.
We will watch our indicator closely and look for it to turn UP from some level which will be our indication to begin increasing risk based assets to portfolios. Caution is still advised as all of our signals are still on a SELL signal at the current time. We still recommend an overweight position in cash and fixed income at the current time and underweight equities with a bias to lower volatility, defensive positions.”
Now that a couple of months have passed the index has shown no sign of an uptick as the economy has continued to deteriorate. Continued concerns over the Eurozone, political bickering and concerns over the domestic economy have provided the crisis that we discussed to push the markets lower.
As with the bullish sentiment composite index noted above the risk ratio indicator is at levels normally associated with good buying opportunities UNLESS it coincides with the onset of a recessionary drag on the economy. During such periods the index can drag into deeper negative territory as we saw going into the last recession in November of 2008. Currently the index is at the same levels once again with the economy on the verge of slipping into a recession. The question now becomes how we can tell the difference?
For that answer we need one more indicator and one that is more directly aimed at timing entries and exits from the markets. (Geeks note: for technical junkies this is a combination of a short and intermediate term weekly moving averages overlaid against a signal line or a composite MACD) The STA Buy/Sell timing indicator has helped sort out the differences between initial downturns, reflex rallies and longer term bottoms as the overall trends were either positive or negative.
If we review our risk ratio indicator, combined with our timing indicator, we can find some clues as to where we are currently. In November of 2007 as our risk ratio indicator was plunging into what should have been a “buying zone” of extreme bearishness the buy/sell timing indicator was just beginning to initiate a “sell” signal warning that prices were moving lower. As a result each successive turn UP of the risk ratio indicator remained short lived as investors were sucked into short term rallies which ultimately failed. It wasn’t until May of 2009 that both the risk ratio indicator and the buy/sell timing indicator gave “longer term” investors an all clear signal to move cash back into risk based assets.
Today, we are witnessing exactly the same set up. The risk ratio indicator is at levels that is bearish enough to warrant a rally. However, with the timing indicator on a clear “sell” signal that rally should be sold into. With no real signs of a potential intervention by the Fed, the timing indicator negative, the economy moving towards recession and the risk ratio indicator in a downward trend the odds of this being the right “buying” opportunity for the next cyclical bull market is extremely small. While there will be short term opportunities for traders in the coming weeks and months; for individuals looking to buy “stocks for the long term” the best advice for now is to continue to hold higher levels cash and fixed income until a safer investment opportunity arises.