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Guest Post: Risk Ratio Turns Up - We've Seen This Before

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From Lance Roberts oF StreetTalkAdvisors

STA Risk Ratio Turns Up - We've Seen This Before

sta-riskratio-120911-3The 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. 

sta-riskratio-120911-2My 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. 

sta-riskratio-120911Today, 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.

 

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Sun, 12/11/2011 - 21:29 | 1968750 knukles
knukles's picture

They said i was all fixed, Goddamnit!

Sun, 12/11/2011 - 21:44 | 1968783 LeonardoFibonacci
LeonardoFibonacci's picture

Let me see. Global financial system about to break down, China looking at a hard landing, EU Euro on the verge of fracturing, US economy scraping the bottom of the pool, US about to implode if Europe crashes, prospects of printing USD galore.....and some say....sell your gold and silver??
 
One thing is certain - nobody knows how this is going to end up, but it wont be good.
 
This is one gun fight I won't be taking a knife to.

Sun, 12/11/2011 - 22:53 | 1968925 philipat
philipat's picture

All those things you mention. Nothing to see there. Move along.

Mon, 12/12/2011 - 01:00 | 1969148 Nobody special
Nobody special's picture

I think you misheard. The instruction was to sell your GLD and SLV. Sell them for real in-your-hand hard currency. <wink>

Sun, 12/18/2011 - 11:51 | 1991462 ThrivingAdmistC...
ThrivingAdmistCollapse's picture

I agree, nobody should be thinking of selling their gold and silver right now.  The entire global economy can collapse at any time, if it implodes precious metals might be the only thing that can help your family.

Sun, 12/11/2011 - 21:45 | 1968785 Crisismode
Crisismode's picture

The 60 Minutes just aired was a complete MSM whitewash of that geriatric scumbag Warren Buffet.

 

Wonder what he paid for the publicity stunt?

Total and completly utter bullshit, promoing his ugly, fat stupid spawn son as the Chairman-To-Be.

Utter, complete bollocks.

Sun, 12/11/2011 - 22:01 | 1968827 oogs66
oogs66's picture

what he was paid?  he is a government employee :)

Sun, 12/11/2011 - 22:22 | 1968881 phungus_mungus
phungus_mungus's picture

History always repeats itself... 

Sun, 12/11/2011 - 21:31 | 1968752 apberusdisvet
apberusdisvet's picture

Who the fuck is in the market now except for brokerages, institutions and funds.  Control your own money bitches, MFG is just the canary chirping infinite wisdom.

Sun, 12/11/2011 - 21:34 | 1968759 SHEEPFUKKER
SHEEPFUKKER's picture

Canary in the gold mine. 

Sun, 12/11/2011 - 21:39 | 1968776 fonzanoon
fonzanoon's picture

Everyone's retirement funds are in the market. Who is in the market now? Everyone, thats who. Should there be some alternative? Yes. Is there? No. Sure physical gold, but we are nut jobs right?

Sun, 12/11/2011 - 21:31 | 1968753 Buttertooth
Buttertooth's picture

Oh it's fixed alright.

Sun, 12/11/2011 - 21:41 | 1968763 DormRoom
DormRoom's picture

hedgefunds, on average, don't produce any alpha [1], while injecting massive volatility into the system.  Why the fck would you want to enter now, weeks/months away from another massive volatility smile, which will break many VaR models.

 

[1] http://www.ft.com/intl/cms/s/0/fcdd7d30-224f-11e1-923d-00144feabdc0.html...

 

The average joe got a mulligan after Lehman.  It's time to exit, and count your blessings. look @ the Shanghai Index.  Its recent declines may indicate heavy carry trade unwinds; a prelude to the end.

Sun, 12/11/2011 - 21:36 | 1968764 fonzanoon
fonzanoon's picture

It may not be fixed. It may eventually fail. But the volume seems to be turned up lately that the sky is about to fall on this site. A huge crash would cleanse the system faster, but people should resign themselves that it may just be a slow bleed out.  It would suck, but life is a bitch right?

Sun, 12/11/2011 - 21:37 | 1968768 SHEEPFUKKER
SHEEPFUKKER's picture

Nice raid on the PM's to start off the trading week. Yeah, that looks normal. 

Sun, 12/11/2011 - 21:55 | 1968813 Mike2756
Mike2756's picture

Not even messing with the pm's, got chewed up trying to figure which way they will go.

Sun, 12/11/2011 - 21:41 | 1968779 RobotTrader
RobotTrader's picture

Yep, silver getting dumped, TPTB rubbing Sprott's nose in the dirt right now.

Can't fight City Hall.

Sun, 12/11/2011 - 22:30 | 1968902 JohnG
JohnG's picture

bullshit.  -.45?  robo, you've gone full retard.  check your meds.

Mon, 12/12/2011 - 00:29 | 1969098 AC_Doctor
AC_Doctor's picture

Hey Robodipshit,  Sprott hasn't got SEC approval to buy the metals yet you total retard.  Everytime silver drops a dollar it means that Sprott's 1.5 billion in cash takes more physical off the already illiquid silver inventories.  It is going to be fun as fuck to watch the shorts get "blowtorched" courtesy of Mr. Sprott, as he lines his pockets off the ignorance of others.

Sun, 12/11/2011 - 21:47 | 1968790 fonzanoon
fonzanoon's picture

yup, for all this rehypothecating crap all over the place the average guy is watching the Giant game with no clue. That may be all it takes to keep the game going/

Sun, 12/11/2011 - 23:14 | 1968956 Matt
Matt's picture

Beer and Football. panem et circenses. I'm sure in some language it rhymes.

Sun, 12/11/2011 - 21:51 | 1968802 chump666
chump666's picture

Thats a good post.  Your dad sounds like a wise man.  Yes this doesn't feel 'right', hence you wouldn't go long in this trade.

Mon, 12/12/2011 - 00:35 | 1969106 AC_Doctor
AC_Doctor's picture

Liquidity is definately drying up even in the face of the recent US Fed Reserve/CB  led emergency dollar funding.  Shit is going to hit the fan soon.

Sun, 12/11/2011 - 22:12 | 1968825 mikejody
mikejody's picture

I don't know how many times that we must say the same thing: the market doesn't read indicators, it reads headlines. The special MACD-Stochastic-Bull/Bear-Volume-reading-can't-fail indicator may cross the threshold telling us to short everything we have, and a headline coming out saying "Euro Deal Reached" and the market will enter a sustained uptrend that will wipe you out. Again, fundamental and technical analysis is worthless in a headline driven market. 

Mon, 12/12/2011 - 06:24 | 1969388 dvsteenk
dvsteenk's picture

yet the half-life of most headline effects has been reduced to a few hours, a day or two at best - in my opinion markets are driven mostly by insider trades, HFT and CB interventions (all manipulations), and the headlines are merely endless post-hoc interpretations of "imminent" or current rallies. Think of chicken and egg cycles...

Sun, 12/11/2011 - 22:03 | 1968832 Caviar Emptor
Caviar Emptor's picture

US market went up last week, cheering the fact that now we're not the only ones looking bad.

From 08-11, you could blame it all on America: the housing bubble, sub-prime debacle, securitized mortgages, excess bank leverage, Lehman-Bear-AIG-Merrill disasters, Wall Street frauds, and the mega-bailouts. 

But now after 4 years of non-stop 3 ring circus acts from the Fed, the spotlight is finally on someone else. The Euro crisis is giving the perfect pretext for the Fed, Wall Street and US banks to start acting smug again. We can start sermonizing about how much better our system is and how they'd be nothing without us. And we can also hope to use those arguments to lure some money away from some panicky investors. 

Sun, 12/11/2011 - 22:14 | 1968860 Georgesblog
Georgesblog's picture

Nothing can feel "right". When the foundation is defective, the house will settle, or worse. If the ground turns into a mudslide, the house can be turned into kindling. The foundation of the markets is the fiat currencies, and the relationships among them. Today's markets are built on shifting sands and imaginary framework.

http://georgesblogforum.wordpress.com/2011/11/02/the-daily-climb-2/

Sun, 12/11/2011 - 22:19 | 1968871 mikejody
mikejody's picture

Just wait, Obama will fix it. He just needs another 4 years to "finish the job". After all, there are 250 million Americans who are still not on Food Stamps.

Sun, 12/11/2011 - 22:21 | 1968876 michaelsmith_9
michaelsmith_9's picture

The USD Index continues to capture my attention, which could be the biggest market influence for 2012.  A big market move is likely to get started with the USD moving higher in the weeks ahead.  Interesting newsletter here with an intermarket analysis outlook for the week.  http://bit.ly/vB9T5P

Sun, 12/11/2011 - 22:24 | 1968884 Caviar Emptor
Caviar Emptor's picture

Everything will be done to make sure that it doesn't happen

Sun, 12/11/2011 - 22:28 | 1968890 slewie the pi-rat
slewie the pi-rat's picture

reminds me of that summer in New Hampshire in the early '80s:

"we're screwed down, here, for life, " BiCheZ! 

Sun, 12/11/2011 - 22:39 | 1968912 laserjock
laserjock's picture

Trust our vaguely-defined proprietary indicator.

Sun, 12/11/2011 - 23:56 | 1969030 sleepingbeauty
sleepingbeauty's picture

That tells us to buy, but doesn't feel right so we are saying to sell. Just because.

Sun, 12/11/2011 - 22:55 | 1968928 oogs66
oogs66's picture

its a buy signal, right?

Sun, 12/11/2011 - 23:21 | 1968966 walküre
walküre's picture

Stop reading the tea leaves.

It will crash when you least expect it. Prepare for it nevertheless. Hindsight is 20/20.

Mon, 12/12/2011 - 01:25 | 1969184 ACP
ACP's picture

Hmm...so the economy was fueled by innovation for 200 years, then the last 30 years by debt and now by monthly bailouts. I wonder what's next? Oh yeah, TILT.

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