The market rallied this past week, albeit in a very volatile manner, to end the week on a positive note as the hopes of a final resolution to the Euro crisis has been reached. In reality, today’s announcement of the EU treaty is only the first step and there are many legal challenges that will still have to be resolved. While the reality is that there is still a very long road ahead before anything will actually be accomplished the implication that the with the ECB willing to buy bonds, at least for the moment, and the coordination of two bailout funds the Eurozone can play “kick the can” for a while longer. Those headlines, even without much substance were enough to drive return starved managers into the market for the year end rush.
Even with the rally today the markets have made very little progress since the beginning of this year. With that I thought it was time update our STA Risk Ratio indicator to see where we currently stand. For reference the STA Risk Ratio indicator is a weekly composite indicator comprised of the Rate of Change of the S&P 500 Index, two different ratio of bullish and bearish sentiment, new highs versus new lows and volatility. This indicator is weighted and then smoothed using an 8 week average. The purpose of the indicator is not to provide trading signals for speculative stock trading but longer term asset allocation changes to adjust for market trend changes and risk management.
As shown in the chart as the indicator rises above 50, and eventually above 100 on the index, the market is becoming overly bullish. Therefore, as a contrarian investment indicator we begin to look for a turn down in the indicator as a sign to begin reducing portfolio risk by raising cash, increasing fixed income exposure, reducing portfolio beta or adding hedges. Conversely, as the indicator falls below 0, and eventually -50 on the index, the market is becoming excessively bearish and we begin to reverse the allocation process.
For example, back in April, and early May, of this year we reduced our portfolio equity allocation levels to the market as the index peaked above the 100 level. By raising fixed income and cash we avoided the majority of the summer decline. As the indicator bottomed and turn up in October we began to add exposure back to the markets.
My father told me long ago, and one of the best pieces of advice he ever gave me, that “when something doesn’t ‘feel’ right – it probably isn’t worth doing.” While my father was not in the investment game; his nuggets of “life” related wisdom have served me exceptionally well managing money. With that begin said there is something that doesn’t “feel” right about where we are.
Besides the fact that our longer term “sell” signals are still in play; the STA Risk Ratio indicator is behaving very similarly to the 2008 market topping process. First of all the current market top is still significantly below the previous 2008 top. Furthermore, in 2008 pay particular attention to the topping action. In mid-2008 the market peaked and made the initial decline, made a solid rally attempt that had the media alight with comments the worst was behind investors and then “BOOM“. During that process the indicator bottomed near -200, turned up signaling an increase to portfolio allocations and then you were promptly pummeled into the actual bottom in early 2009. The difference is that in “bearish markets” turn ups in the indicator tend to denote bear market rallies rather than bull market advances. With most of our market signals still in bearish territory and the markets remaining in a bearish trend since the peak – market risk remains elevated.
Today, we see the very same pattern emerging…and it doesn’t “feel” right. This is particularly concerning as we head into 2012 and potentially a very turbulent political election cycle, earnings compression due to the end of a profit cycle, a domestic economy that is currently in a “struggle to muddle” through phase, a slowing China, a recessionary Europe and plenty of potential for further crisis’ from the Eurozone. We have been here before.
Back on August 31st we wrote: “So far, none of this takes away from the larger fact that the economy is slowing down, corporate profits are weakening, and there is a lot of risk contained in Europe that could back-splash very rapidly into the U.S. This is clearly a bounce within a negative market trend at the current time and is not a new bull market to chase. With fundamentals of stocks deteriorating along with the economy, we see NO reason to take on excessive speculative risk at the current time. We are most likely witnessing end of the month portfolio rebalancing as the markets head into a long labor day weekend market. The light volume rally also does not invoke confidence in a continued push higher.
It is ALWAYS better to wait for the signal to change rather than trying to anticipate the change…many people have been hit by buses trying to jump the light. Therefore, we don’t recommend chasing this rally until signals clearly provide a better opportunity.
Our primary buy/sell indicator is still firmly in SELL territory which automatically reduces equity exposure by 50% from normal allocations and increases fixed income holdings and cash. Until this indicator turns back to positive we will remain underweight in our models in equity and simply use the shorter term signals as noted above as trading opportunities to create additional alpha until such time as the risk/reward ratio is clearly aligned back in our favor.”
We wrote that just before the bloodbath in September. This is why we are currently positioned with higher than normal levels of cash and fixed income until our longer term “buy” signals come online. While “this time may be different” as long as we remain on a longer term market “sell” signal the cushion of cash gives us some flexibility to add beta if the market continues to rally. However, and most importantly, cash provides us a “safety net” to rework portfolios should this rally fail and begin to push back toward market lows.