Guest Post: Pavlov's Dogs - An Overview Of Market Risk

Submitted by Pater Tenebrarum of Acting Man blog,

Risk and Certainty

It is always amazing to observe how people become less risk averse after risk has markedly increased and more risk averse after it has markedly decreased.

The stock market is held to be 'safe' after it has risen for many weeks or months, while it is considered 'risky' after it has declined. The bigger the rally, the safer the waters are deemed to be, and the opposite holds for declines. At the March 2009 low, the daily stock market sentiment index (DSI, a daily sentiment measure of  futures traders) had declined to an all time low of 3%. In other words, 97% of traders were bearish at the lowest risk buy point of the past 15 years.

One term that is associated in peoples' minds with rising prices is 'certainty'. For some reason, rising prices are held to indicate a more 'certain' future, which one can look forward to with more 'confidence'. 'Uncertainty' by contrast is associated with downside volatility in stocks. In reality, the future is always uncertain. Most people seem to regard accidental participation in a bull market cycle with as a kind of guarantee of a bright future, when all that really happened is that they got temporarily lucky.


Short sellers are a very small group of market participants. This is not surprising. For one thing, falling stock prices have negative psychological connotations. Most people naturally gravitate to the optimism attending rising prices. For another, the gains a short seller can make are limited, as a stock cannot go below zero. Last but not least, stocks (as measured by stock indexes and averages) actually rise about two thirds of the time. This is mainly due to two reasons: constant monetary inflation and the 'survivor bias' of the indexes.

Short sellers don't have it easy – their research has to be superior to run-of-the-mill research, they are often forced to endure mass outbreaks of irrationality (think internet bubble) and when prices actually fall, they are usually vilified and falsely blamed for 'making' prices decline.

To this day many people are e.g. blaming the failure of Bear Stearns and Lehman to short selling activity in their stocks. In reality, both firms were stuffed to the rafters with worthless mortgage-backed toxic dreck on extreme leverage and were essentially among the 'walking dead' in the weeks preceding their downfall. The short sellers were merely cognizant of this reality.

As noted above, the market rises about two thirds of the time, so it is generally safer to be a bull. For instance,  perma-bullish analysts like Laszlo Birinyi or Abby Joseph Cohen can be sure that they will be right 66% of the time by simply staying bullish no matter what happens. This utter disregard of the risk- reward equation can occasionally lead to costly experiences for their followers when the markets decline. For instance, A.J. Cohen's 'must own' basket of technology stocks for 2001 eventually declined by nearly 90%. Laszlo Birinyi fell in love with a subprime lender in early 2007 due to its high yield. To be sure, he didn't recommend to bet the farm on it (quote: “Don't put your retirement funds here or take a large position, but at four times trailing earnings, it's cheap. And there has to be a bottom somewhere.”). There actually was a bottom somewhere: strong technical support was found at zero.  



The 'risk appetite index', an amalgam of the Citigroup Macro Risk Index, Westpac Risk Aversion Index and UBS G10 Carry Risk Index Plus. The herd simply follows prices – click for better resolution.



A Well-Trained Herd

What makes the current juncture especially fascinating is the fact that the Fed has fired its 'QE' bullet at a time when 'risk assets' appeared already fairly overbought and inflation expectations were near the high end of the range of the past five years.

Few people seemed to take this fact into consideration: the herd has been well-trained by Ben Bernanke and reacted according to the experience made during the last two 'QE' iterations. Note however that $40 billion per month in additional Fed balance sheet expansion isn't what it once used to be. It remains to be seen how much of it will 'leak out' into the money supply (this will partly depend on how many securities are bought from non-banks and what the banks decide to do with the additional excess reserves that will be created).

The point is that there is actually no precedent for the current situation. Previously the Fed intervened or announced upcoming interventions at junctures when the markets were in trouble and close to 'oversold' status, with inflation expectations very low. Note in this context that former 'hawk', Minneapolis Fed president Narayana  Kocherlakota has joined the dovish camp at this rather unusual point in time.  The recent burst of market enthusiasm has meanwhile been accompanied by an inordinate number of technical divergences, including a strong warning sign in the form of a Dow Theory divergence between industrial and transportation stocks.  All of these are to be filed under 'they won't matter until they do', but it would be a mistake to simply ignore them.




5 year US inflation breakeven rate (this is calculated by subtracting the yield of inflation-indexed securities from nominal treasury bond yields) – click for better resolution.




A wedge-like advance in the SPX – click for better resolution.




The broad market as represented by the NYSE composite index continues to diverge markedly from the SPX – click for better resolution.



As EWI recently pointed out, the only stock indexes that have been rising strongly are those with active futures contracts. Furthermore, an index constructed of the 75 stocks with the biggest institutional ownership is still vastly underperforming the rest of the stock market.




The 'institutional index', a cap-weighted index of the 75 stock with the biggest institutional ownership – click for better resolution.



There have been a number of interesting developments in positioning indicators and surveys. For instance, the dollar-weighted net short position held by commercial hedgers in stock index futures is close to an eight year high. The Rydex bull/bear ratio is literally 'going off the charts', as does speculation in call options.

This is in sharp contrast with the average recommended Wall Street strategist asset allocation to stocks, which stands at a mere 41.5%, the lowest level since the early 1980's. This latter phenomenon goes hand in hand with historically high values for the 'policy uncertainty index'.

Among sentiment polls, we find the Market Vane and Consensus Inc. bull ratios  quite stretched at 69% and 72% respectively, while the Investors Intelligence bull ratio at 0.69 is 'getting there' (its historic highs are in the high 0.70's). The AAII (American Association of Individual Investors) bull ratio by contrast stands at a fairly middling 0.53%.

The CSFB 'fear index', a variation on the Ansbacher index which measures the relative prices of out-of-the money calls and puts on the SPX (the CSFB index measures a 'zero cost collar' – it determines how far out of the money the next put is that one can buy for the premium received for selling a 10% ootm call) stands at the highest level since late March, a sign that professional investors are eager to hedge their positions with SPX puts (note that this is not a contrary indicator).

To this we would note that the main difference between the indicators listed above that are in such unusually strong opposition to each other is that positioning indicators that measure what market participants are actually doing with their money mostly show that traders are betting on a continuation of the rally. By contrast, the indicators that are contrarian bullish are of the anecdotal variety: Wall Street strategists make recommendations, and 'policy uncertainty' likewise expresses mere opinions. There is often a difference between what people say and what they do.




The Rydex bull-bear asset ratio has recorded multi-year highs in 2012 – click for better resolution.



Another measure of risk appetite is the silver-gold ratio. In a way it is the equivalent of a credit spread (we have discussed the topic in detail in “The Gold-Silver Ratio as an Early Warning Indicator”).

The silver price will tend to rise relative to the gold price when economic confidence is waxing – i.e., it will exhibit a tendency to follow the stock market. There are occasional exceptions to this rule: historically these have occurred when deep-pocketed investors have piled into silver (the Hunt Brothers in the 1970's, and the Sprott funds in early 2011).

Bob Hoye notes that whenever the RSI of the silver-gold ratio approaches the 90 level, one must begin to exercise caution and watch for a potential reversal in the ratio (as you will see below, this rule can also be temporarily invalidated). The occasional signal failure should not detract from the signal's validity: similar to all technically based indicators it only informs us about probabilities. The reversal following a high RSI reading is often a sign of impending liquidity trouble. The indicator is at present in 'heads up' mode.



The silver-gold ratio: a dangerously high RSI reading has been recorded, but there is as of yet no reversal – click for better resolution.



The Dow Transportation Average versus the Industrial Average (yellow line): A tale of two divergences: in 2007/8 the transportation stocks made a higher high relative to a lower high in industrial stocks. This time the opposite is happening, as economically sensitive cyclical stocks have generally weakened relative to defensive stocks.

Only 20% of the stocks in the Transportation Average are above their 200 day exponential moving average, so its internals are even worse than the price level of the average would suggest – click for better resolution.



We have mentioned extremes in speculation in call options above. There has recently been an interesting development in that context that deserves attention. First we show the 'options speculation index' published by sentimentrader – this is an index that measures opening transactions across all US options exchanges and compares all bullish against all bearish activities (buying calls to open and selling puts to open counts as bullish while selling calls to open and buying puts to open is counted as bearish). This is one of the most comprehensive indicators of option trader sentiment. It has spent a great deal of time in rarefied air since early 2010. It is noteworthy that extremes have not always had an effect right away and often it has paid to wait for divergences between prices and the indicator. Still, it is once again well above the levels seen near the 2007 highs.


The options speculation index is back in 'red alert' territory – click for better resolution.



It is interesting how a specific group of traders has behaved, namely those buying 50 or more contracts at a time. There has been a big spike in call buying by these traders. Unfortunately interpretation of their behavior is not straightforward – but if we were to guess, the most likely reason was probably to retain exposure to further upside after taking profits in the underlying stocks. Note that the equivalent 'small trader' put-call ratio also shows growing enthusiasm for the rally, although it still slightly below past extremes.



Large traders have suddenly piled into calls – click for better resolution.



Finally, two further indicators that are illustrating the current sentiment picture. The first is the NAAIM active managers survey. A detailed description of the indicator can be found at



The NAAIM active fund manager sentiment. Responses can range from '200% short' to '200% long'. From these responses a mean showing 'net average exposure' is constructed – click for better resolution.



In connection with the NAAIM survey, there was an interesting occurrence in the late July summary. A list of the weekly responses is depicted below. Note the two columns labeled 'bearish' and 'bullish'. These show the extremes recorded at every weekly survey, this is to say the net positioning of the most bearish and the most bullish manager. On July 25, the most bearish manager was flat, while the most bullish manager was 200% long:



Summary of NAAIM responses since July 18. On July 25 a highly unusual combination was recorded: the most bearish manager was merely flat, the most bullish one was 200% long.



At the time this reading was recorded, Jason Goepfert of sentimentrader created a statistic that shows all the previous occurrences of this combination and the subsequent market performance over short to medium term time horizons. Note that the relatively low mean recorded in this particular week may weaken the message of the signal somewhat, but his is still an interesting statistic:




The market's performance subsequent to the 'no net short, most net long 200%' combination in the NAAIM survey. It has already happened twice in 2012, the first time was on May 16. As an be seen, this has often been followed by very weak market returns going forward, however one should keep in mind that the survey only exists since 2006, so many of the readings happened to occur during the bear market of 2007-2009.



Lastly, a chart that shows the current Rydex bond ratio. This ratio is calculated by dividing the total assets in Rydex Inverse Goverment Long Bond Fund (bearish on bond prices) by the total assets in Rydex Government Bond Fund 1.2x (bullish on bond prices). The higher the ratio, the more assets are devoted to shorting the long bond.

It didn't take long for the bears to pounce – there is a large contingent of traders waiting to 'catch the top' of the treasury bond market. This makes us think that the US treasury bond market will over time become ever more akin to the JGB market, this is to say it will probably remain at very low yields for a very long time (although upside progress will obviuously be limited with yields already near all time lows) . By the time the actual turn comes, people likely won't be inclined to short the market that quickly. It is noteworthy that the highs in the ratio are steadily declining, but all in all this seems to be a decent contrary indicator.



The Rydex bond ratio: currently 4.86 times more assets are devoted to shorting the bond market than are in the fund that bets on higher bond prices. In the past, peaks in the ratio have usually coincided with lows in bond prices – click for better resolution.



Note in this context also an article that appeared late last week at Bloomberg: “Bearish Treasury Bets Hit a Record Amid Inflation Concern


Options traders are paying record prices to protect against swings in long-term U.S. Treasuries relative to stocks amid concern inflation will accelerate.


Implied volatility, the key gauge of options prices, for contracts with an exercise level closest to the iShares Barclays 20+ Year Treasury Bond Fund (TLT) has climbed to 16.65, compared with 13.85 for the SPDR S&P 500 ETF Trust (SPY), according to three-month data compiled by Bloomberg. The ratio between the two ETFs reached 1.24 on Sept. 14, the highest since at least 2005.”


(emphasis added)

It is probably fair to assume that the next low in bond prices will happen concurrently with a peak in the stock market.


Addendum: A Few Words on Gold

When we wrote last about gold and gold stocks it was fairly easy to adopt a constructive stance, as the sector was very oversold and sentiment was almost uniformly bearish. For instance, we concluded “Gold and Gold Stocks, A Technical Update” by writing:


“Given the bullish fundamental backdrop for gold – real interest rates remain negative and central banks seem eager to resume monetary pumping as economic confidence once again wanes – the probability is high that the current consolidation phase will once again lead to an upside breakout. If this is indeed the case, then gold stocks are a screaming buy at current levels, in spite of all the well documented [operational and cost] problems.”


We further documented the bottoming process in mid August in “Gold, Silver and Gold Stocks”, coming to a similarly positive conclusion. To be sure, we didn't expect the sector to decline as much as it did before putting in a reversal, but these two articles are probably worth revisiting for future reference, due to their extensive overview of the technicals: this is what tends to happen at lows.

We will soon revisit the topic in more detail again, but wanted to note on this occasion that it is not so easy anymore now that the metals as well as the mining stocks have risen quite a bit in a very short time. One possibility that occurred to us is that the current move to the upside will resemble the preceding downtrend in some respects – i.e., it could be that it will be similarly relentless. It should be noted though that this is actually a low probability bet. It is more likely that some sort of short term correction will soon begin, leaving the medium term uptrend intact. The reason to expect that the uptrend won't end on an intermediate term basis yet is that the ratio of gold stocks to gold has finally decisively reversed its previous downtrend.




The HUI-Gold ratio has broken through a downtrend line that has limited advances for more than a year. It is actually astonishing that a ratio chart is hewing so closely to technical levels. Note that lateral resistance awaits at the 0.31 level – click for better resolution.


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