COTD: Risk Ratio Pushing Extremes
Over the past couple of months I have been discussing the rising risk in the markets as asset prices have been propelled higher by continued Federal Reserve monetary actions even as corporate earnings have weakened. In particular, in the post titled "There Is No Asset Bubble?", I stated:
"Don't misunderstand me. As we wrote last week - it is certainly conceivable that the markets could attain all-time highs. The speculative appetite combined with the Fed's liquidity is a powerful combination in the short term. However, the increase in speculative risks combined with excess leverage leave the markets vulnerable to a sizable correction at some point in the future.
The only missing ingredient for such a correction currently is simply a catalyst to put 'fear' into an overly complacent marketplace. There is currently no shortage of catalysts to pick from whether it is further fiscal policy missteps stemming from the upcoming 'Debt Ceiling' debate, a resurgence of the Eurozone crisis, or an unexpected shock from an area yet to be on our radar.
In the long term it will ultimately be the fundamentals that drive the markets. Currently, the deterioration in the growth rate of earnings, and economic strength, are not supportive of the speculative rise in asset prices or leverage. The idea of whether, or not, the Federal Reserve, along with virtually every other central bank in the world, are inflating the next asset bubble is of significant importance to investors who can ill afford to once again lose a large chunk of their net worth."
The recent events in Cyprus certainly fall into the last two categories of potential catalysts outlined above. Here are some of the potential risks currently:
- If depositors actually do lose a chunk of their principal due to bank confiscation it could conceivably cause a "run on the banks" in other weak countries causing further financial stress.
- The bailout of Cyprus clearly shows that Mario Draghi's "jawboning" to temporarily smooth over the Eurocrisis has not done anything to actually make progress in solving it.
- The hardline taken by Germany in regards to the bailout of Cyprus shows that their future tolerance to "go along" is waning. This could very likely lead to further confrontations in the future that could ignite Eurozone concerns.
- If Cyprus doesn't go through with this bailout agreement, vote has been delayed until Thursday, the potential collapse of financial institutions in Cyprus could well spark a panic throughout the Eurozone.
- Italy, Spain, Greece are not out of the woods. Don't be surprised to see these countries back in the headlines sooner rather than later.
This bring us to today's Chart Of The Day which is the Composite Risk Ratio indicator. As we have discussed in the past this is an 8-week moving average of the combined data including the S&P 500 price momentum, investor confidence, high-low index, and volatility.
As you can see the composite risk index has now climbed into bullish extreme levels that we have generally only seen at or near fairly important market tops. There are several important points to make note of:
- Just because the index is at extreme levels does not mean that a correction is immediate. However, when this composite index has turned down from current levels it has historically signaled the peak in the market and the beginning of a coming correction.
- Since an 8-week moving average of the data is used, to smooth otherwise very volatile data, the market will likely lead the indicator into the next correction. Therefore, some portfolio management controls should be implemented to reduce risk in the short term. (i.e. take profits, sell losers, increase fixed income and/or hold higher than normal cash levels.)
- High levels of "complacency," as currently witnessed in the markets, and as shown above, is dangerous. This is especially true when combined with high levels of leverage and a chase for yield that has pushed speculative "junk bond" yields to record lows.
Will Cyprus be the needle the pop's the current "balloon?" It's possible and the next few days will be very telling. In the short term, if things are handled very carefully, it could well provide the catalyst for a 10-15% correction in the markets. If that happens - it could happen very quickly leaving investors little time to react. Of course, this is how it always happens and why investors wind up continually selling at bottoms. Be prudent, implement some risk management controls in your portfolio and have some cash ready to deploy when things get cheap. Isn't that what we are supposed to do anyway?