Guest Post: Risk Ratio Indicating More Correction Coming

Tyler Durden's picture

Submitted by Lance Roberts of StreetTalk Advisors

Risk Ratio Indicating More Correction Coming

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 becoming whether the current correction is over or is there more to come?

It always fascinates me to watch the media during market rallies as the bullish sentiment takes hold. There is never a word of caution offered to investors 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?"

sta-riskratio-051812Going 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 major rout is very tough, if not impossible, for almost every investor as 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 the most common measures of investor sentiment including 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 using weekly data combined 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 with it 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.

sta-riskratio-051812-1If 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 similarly 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 can not 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 drive 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, can help us 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"

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jcia's picture


jcia's picture


This is your chance to show the people of the world that Keynes >Hayek

jcia's picture

Uncle Warren needs to invest 10billion in FB.

Beam Me Up Scotty's picture

Uncle Warren should go "all in".

bdc63's picture

"More Correction Coming" ... Bring it on!

The trend is your friend's picture

unless their is a 15-18% pullback their is no way the fed can justify a QE.  Down she goes to 1255


" Risky Business " NEW NAME FOR Face Plant IPO Part Two, Redux.

Debtless's picture

There's still time for FB to double today. /s facepalm

carbonmutant's picture

When you're born a dog you die a dog...#FBipo

dwdollar's picture

MUST... KEEP... FB... GREEN... UGH...

catacl1sm's picture

algos have had to dump supporting the DOW in favor of FB.

Freddie's picture

I wish you people would stop "hatin" on Facebook.  Everyone loves FB.

cbxer55's picture

I am sure your being facetious. But I red-arrowed you anyway for doing so on the noted hateful subject. ;-)

Caviar Emptor's picture

This is the end : 

CNBC Top Stories:

Memo to Nouveau Tech Riche: Don’t Flaunt It  


You mean greed isn't good anymore??

unununium's picture

Bid qty is pegged at 9999900.  TPTB just aren't going to let the muppets take a loss on the first day.  Wish I could short 10 million shares...

Debtless's picture

Patience you must learn young jedi. Short we will when the time comes.

unununium's picture

Someone spent over $1.1 billion so far today getting their bid hit at $38.00.  $200M in the last 10 minutes.

cbxer55's picture

I read on a Yahoo article that two of the TBTF banks bought major shares at the end to prevent it going under $38.00.

FED to banksters: Use some of that bailout money to keep this one green.

Banksters: Yessir Uncle Fed. Bombs away!

scatterbrains's picture

I keep thinking Dimon is playing chicken with the Berstank. Who's gonna blink first bitches ? 

earleflorida's picture

It's a Rockefeller [Whale Shark] Bank in a Rothschild's [Blue Whale] World, period!  They [Jamie's Gang] fucked-up big time,  and have brought [unnecessary exposure] the shadows out of the night with only a pen-light of petty-greed. Remember this about shadows - if left alone to their devious dark, and diabolical intangible selves,... unimpeded by sunshine, their macabre  fraternity only strengthens their insidious resolve, manifested 'souly' on its orchestrated web of deceit!      

franzpick's picture

Let's see how the issuers 'like' supporting the $38 PhaseBook offer over the next few days during the impending financial equity collapse. 

carbonmutant's picture

When you're this oversold and you get no bounce something is rotten in Denmark... Minyanville

Cognitive Dissonance's picture

Most oversold conditions correct themselves.

And a few don't.....and just become even more oversold. Those times are for those with big hairy........well, you get the picture. :)

carbonmutant's picture

Like Warren said, "when the tide goes out you can see who's got the cojones"

Mark123's picture

Some serious selling pressure today.  I wonder what the weekend holds in store?


Likely Greece was told they could not go full default until AFTER Facebook IPO. 

Trimmed Hedge's picture

WTF did my FB profitz go??

Debtless's picture

Some clown just blamed FB on Greece. Where do they find these assclowns?

junkyardjack's picture

I'm waiting for the announcement that Facebook has effectively been taken back private as the underwriters bought back all shares outstanding at $38 to support the price....

Mark123's picture

classic comment!  the market has become Dumb and Dumber.


Can't wait for satirical movie of Facebook starring Jim Carey as Zuck.

Debtless's picture

The writers thought this stock was gonna be a nickel front-runners dream. Fuck them. I hope they hold all of it at 38 by monday noon.

monopoly's picture

Yup, you know it is not the retail investors keeping this social piece of crap up. Patience.

Debtless's picture

$38.000000000001 Success!

junkyardjack's picture

$38.23.  Wall Street finding its harder to pedal bullshit when retail has left the market...

Mark123's picture

Get ready for it....The spin....FB IPO was a GREAT success - given that europe's problems dragged it down so much.  Jus shows how powerful this stock is, and gee, what a great opportunity for the smaller investor to get in.  Blah, blah, blah....

catacl1sm's picture

$38 will be the Maginot line on Monday.

ACP's picture

The only problem is...the last time this exact same scenario happened was in 2007, when the market when on later to make the "head" of the H&S formation.

Venerability's picture

Everyone seems to be 100 percent Bearish - so Bearish, Professor Roubini now seems to be the Pollyanna.

The rupee and naira and so many other currencies at all-time lows against Dollah! Dollah! Dollah! are not good for anyone, the US included.

The World - collectively - is not a few bullying traders. even though it sometimes seems it is.

The World - collectively - does not want a repeat of 2008.

So the World - collectively - will tone down the rhetoric on Oil, studiously ignore Gold and Silver, and intervene overtly or covertly against a too-strong Dollar. 




q99x2's picture

FB should help to keep the correction going for a little while.

BeetleBailey's picture

Bob Farrell's rule #9 is: "When all experts and forecasts agree — something else is going to happen." 

Then......Facebook will crater to $10, however, the overall market will soar.

But then......the Euro should beat the crap out of everything too..........

Duly noted.

New_Meat's picture

good catch on Farrell vs. Skoval

1eyedman's picture

these charts are nice, but suck.  you'd have been on mid 05 through 07; then whip=sawed on the way down in 07 and 08; then in and out again mid 2010....and now, the 'instruction' hasnt triggered, simply an 'alert' and now -8%.    the bulls love 8% turndowns, it just barely trips the numbers to add at lower me it looks like it should/could get bullish again, for an extreme reading....which was approximately good for the 07 top (but many months waiting)....


imagine the bullishness after -9%, and then +6%...still at 1370-ish, and a 80 point recovery..'antoher 80' will it at new highs!"....hopium doesnt need much water to grow.....  when the new 'action' by CBs is short-lived and doesnt stick for more than a couple weeks.....THATs the real deal, and you shouldnt have anything except cash under your mattress.

....if you have margin at your more than likely allow them to lend out your shares....think rehypothication, think margin calls globally,  think PMs are sold for liquitdity.....

Landrew's picture

I have to agree with a pop to the resistence of the 50 day ma. Sold the last of my June puts today. The pop up to the 50  I will buy July at the money puts on the top four dow, BAC,GE,CSCO and INTC. Any thoughts?

dizzyfingers's picture

"This statement encapsulates the basic tenant of being a contrarian investor."

Tenet, not tenant!

Definition of TENET : a principle, belief, or doctrine generally held to be true; especially: one held in common by members of an organization, movement, or profession See tenet defined for English-language learners » See tenet defined for kids » Examples of TENET
  1. the central tenets of a religion
  2. one of the basic tenets of the fashion industry
Origin of TENET Latin, he holds, from ten?re to hold
First Known Use: circa 1600