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Risk Management

Market Indicators

One of the key parts of investing is risk management. Sometimes the hardest decision looks like the wrong one until it is proven right. For me, the hardest decision has been to raise cash for the past four months or so in the face of a rising stock market.

However, given that the market has been moving higher on low volume, the fact that the internal mechanics of the market have been deteriorating over this time frame, and that there is speculation about whether the Fed will continue its bond buying activity that has pushed the market higher – I feel we need to be prudent by having higher than normal levels of cash so that we can reinvest it when the market corrects.

It is tough to watch the market move higher on a near-term basis and not be fully invested, but by following proven risk management strategies, you always win in the long-term. The current market is much like what we saw with NASDAQ in 1999 and 2000 – albeit to SIGNIFICANTLY smaller extent.

The market continues to move higher as new entrants put money into it several years into its bull market run, at a time when earnings growth has diminished – but the new entrants’ money expands P/E multiples to move the index higher.

This is what happened to the NASDAQ on a much bigger scale, but it is also happening to the S&P 500 right now – and it is wise to learn from the past in order to be successful in the future.

As the market has been moving higher (or more accurately sideways with a slight upward tilt for the past few weeks) on low volume – there just are not that many institutional investors participating in the move, but instead its retail investors who missed much of the move off the March 2009 lows – I wanted to show you the market indicators that I follow that have me wary of the validity of these new highs.

But, to put things in perspective, even though we are positioned very conservatively at the moment with respect to the stock market, our fully diversified equity accounts have averaged 17.82% net of all fees since March 2009 compared to the comparative blended index of 16.90%. I am OK being under weight equity exposure in the short-term so that we can protect those gains for the long-term – especially in light of the current readings on the indicators I follow which are shown above (you can double click the graphic to see a larger version).

I use these sorts of indicators – and many others – as a risk management tool. It is a difficult decision to raise cash as the market goes higher, but when the indicators flash a warning it pays to heed their signal – even if you look dumb (or as I prefer to think of it, conservative) in the near-term.

The upper left hand corner chart above is the Bullish Percent Index (the red line) overlayed with the S&P 500 Index (the green line). The BPI is a breadth indicator that tells us the number of stocks with a bullish chart pattern – as a contra-indicator, this one basically says that when things are overly bullish there is too much excitement in the market and it is due for a rest.

When you look at this chart, you see that moves above the upper blue boundary line are relatively short lived, and always result in a market that pulls back several percent – last year about this time the market topped out and pulled back 10%. A move below the bottom blue line is always a good time to buy into the market as it precedes a several percentage move higher.

The HiLo indicator is just below the BPI. You can see that it is also above its upper indicator. This indicator measure the number of new highs net of new lows. Again, this contra-indicator shows us when there is too much excitement in the market. Moves above the upper boundary line precede pullbacks in the market, so it is saying that caution is warranted.

The chart below the HiLo Indicator is the number of stocks in the S&P 500 that are trading above their 50 day moving average. You can see that this one is already in correction mode with a move below the upper blue line – and that generally precedes a pullback in the market.

The chart below it is shows us the number of stocks trading above their 200 day moving average. This is a more intermediate term chart and can have readings above the upper boundary for a considerable time. However, once the chart above it moves below, we start to watch for this one to correct as well.

The Volatility Index chart at the top of the next column shows us how much fear or complacency is in the market – right now, we have extremely complacent readings.

The Advance Decline graphs below it are significant to the extent that the blue line is trending below the red line which tells us that the market is weakening and that we have fewer stocks advancing in price than we did on average over the past 30 days.

The final two charts are price oscillators that differ primarily in their timeframes. It is easier to spot short-term changes on the top one and easier to spot trend changes on the bottom one. The bottom one to me is saying that the price trend has rolled over but it needs to be confirmed by a move below the upper blue boundary line.

S&P 500 Index with Bolinger Bands

The graph above includes two green lines that acts as bands around the S&P 500 Index over the past year, and you can see the big pullbacks from April to June 2012 and September to November 2012. Both of these corrections were in the 10% range, so I believe there is every reason to assume that we can have a similar type of pull back – the issue is as always the timing of it.

The green bands I mentioned earlier are called bollinger bands and they represent a measure of volatility – when the bands get too narrow, the market has become too complacent and we should expect some event that will increase volatility and send the index either higher or lower depending upon investor sentiment.

Sentiment Indicators

I’ve included the chart above from Barrons so you get a feel for current sentiment readings. Sentiment is a contra-indicator (meaning that high/bullish readings are signs of a market top and low.bearish readings are signs of a market bottom).

Looking at the readings here, they are at the high-end of the range, indicating to me we are nearing a correction, but not so high that it would mean any correction would be extended in duration – much like the two 10% corrections from 2012 we experienced.

10-year Treasury Note Yield

One of the primary determinants of sentiment is interest rates, and the key rate to watch is the yield on the 10-Year Treasury Note. As you can see on the chart above, we have been in an upwardly trending pattern for the past four months. At the current level of 1.88%, we are still experiencing very low interest rates in our economy, rates that are stimulative (or should be in normal economic circumstances).

If I were to pick one issue that could lead to a correction larger than the normal ones of 10% we saw in 2012, I’d pick a continuation of this trend that showed an increase in the 10-Year Treasury yield to 2.50%. Will that happen?

There are some economists that are forecasting such a move – but they have been forecasting an increase for the past couple of years so you have to ask: is there something different today than 2011 and 2012 that would make that forecast become a reality.

Goldman Sachs seems to believe that what we will see is a move by the Federal Reserve to stop buying Treasury Notes as part of their Quantitative Easing activity (their current method of stimulating the economy by buying bonds as a way to get newly printed cash into the economy). The economists at Goldman believe that the Fed will continue to purchase mortgage backed securities in an effort to keep the monetary stimulus in place, but will simply no longer purchase treasury notes as part of their activities.

If that is the case, we then have a supply/demand imbalance (the US Treasury has more supply – they need to issue the bonds to fund the deficit – so they will have to stimulate demand by offering higher yields). Given some of the interviews of Federal Reserve Governors I’ve been watching, there seems to be some support for Goldman’s view.

Obviously, we will not know anything about the Fed’s plans until they tell us. However, long before there is a public announcement, the markets will react based upon speculation about their plans – that is just the nature of the investment process.

One index I like to watch that is closely tied to interest rates is the mortgage index.

Mortgage Index with S&P 500

I have overlayed this index with a green line that represents the S&P 500. If you look closely, you can see that the general trend of the two prices move together, with movements in the mortgage index generally preceding movements in the S&P 500 index.

Mortgage Index - Past 3 Months

What I really want you to see is the past three months movement on the graph above, so I have shortened the time frame to make it easier to see what is happening right now.

You can see that we have had a significant drop in the mortgage index (the red line) without yet having a drop in the S&P 500 (the green line). This is just another sign of caution as mortgage investors seem to be anticipating higher rates – but we do not yet know if that will translate into equity investors anticipating the same thing. If it does, then we will see a pullback – if not, our sideways pattern of the past few weeks will continue

So, for now, based upon the indicators that I follow, the higher than average sentiment indicators, and the upward trend in treasury yields, caution is the word.


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Mark