# SPX: Reviewing Risk/Reward And Entry Targets

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October 23, 2012

For the last several weeks we have been discussing the overbought conditions of the market and that on a risk/reward basis investors would be substantially better off to wait for corrections in the market before adding equity exposure.  At the beginning of September (Sept. 8) we discussed the calculation of the risk/reward ratio with the following example:

“The most likely maximum upside in the markets today from current levels is the 2007-2008 market peaks of 1565.  The markets closed on Friday at 1437.92 (we will use 1438 for this example.)
If you invested \$100,000 at the close of the market your most logical maximum return (or reward) will be:1565 ÷ 1438 -1 = 8.83%
That is not a bad return from current levels.   However, what if things do not turn out as planned?  There are two key support levels for the market which are 1) the uptrend line at 1325 and; 2) May lows of 1275.  However, it is also possible we could see a retracement to the 2011 lows of 1150.
These three scenarios give us potential losses (or risk) to our portfolio of:
• Scenario 1) 1325 ÷ 1438 – 1 = -7.8%
• Scenario 2) 1275 ÷ 1438 -1 = -11.34%
• Scenario 3) 1150 ÷ 1438 -1 = -20.03%

Therefore, as an investor we can now relate the RISK that we are taking with our \$100,000 investment as follows:  \$100,000 X .0883 = \$8,830 (potential reward)Versus the potential risks:

• \$100,000 X -.078 = (\$7,800)
• \$100,000 X -.1134 = (\$11,340)
• \$100,000 X – .2003 = (\$20,030)

Therefore our risk/reward ratio on this particular bet is:

• Scenario 1) 1.13 : 1    (Reward is 13% greater than the risk)
• Scenario 2) 0.78 : 1    (Risk is 22% greater than the potential reward)
• Scenario 3) 0.44 : 1    (Risk is 56% greater than the potential reward)”

Understanding this is important in understanding how much of your investment capital you put at risk in the market.  If you are right and the market reaches the maximum expected target then you will stand to make \$8,830 which is 13% more than you will lose if you are wrong with scenario 1.  However, every other scenario had negative consequences.”

That was at the beginning of September.   Now, over a month later the market has gone virtually nowhere with the market sitting roughly at 1432 as of this writing.  The premise at the beginning of September was that with all of our buy signals in place, the announcement of QE-3 by the Federal Reserve, and the onset of the seasonally strong period of the year, that exposure to the equity markets would need to be increased.  However, the risk was that the sharp advance in the summer, on expectations of Fed action, had priced in much of the potential gains.  We have repeatedly stated since that time that corrections in the market was needed to provide a better entry opportunity.  That advice has continued to play out in our favor.

Resetting Target Entry Levels

We have been pointing out for several weeks now that the deterioration of earnings since the beginning of the year is very concerning.  The recent misses by INTC, GOOG, IBM, AMD, CAT, FDX and many others has been a clear warning that the current economic and fundamental environment has been far weaker than what the market is currently pricing in.  Furthermore, market participants have been exhibiting an extreme level of complacency which is generally indicative of near term market tops.   The 4-Panel chart below shows the market as compared to four different “complacency” measures that we track.

These overbought, over complacent, conditions have been indicating that a correction in the market was needed before further advances into the end of the year could occur.  That corrective process has occurred over the last couple of weeks and on a very short term basis, as we showed earlier this week, the market is now very oversold.

This oversold short term condition currently allows for adding equity exposure to portfolios at a lower level of risk than just a few weeks ago.  With this oversold short term market condition, combined with our buy signals remaining intact, we can recalibrate our target entry levels for additional exposure, our stop loss point and relevant risk/reward ratios.

The first level of support for the market is at 1426 which is the rising short term weekly moving average.  The second target entry level, should current support levels fail, would be the 38.2% Fibonacci retracement level at 1395.  This second level of support also coincides with our long term weekly moving average making this a very important support level and one that should hold if the market is to make a rally attempt into the end of the year.

Should the markets breakdown through this important support it will likely mean that some other event has occurred.  At this point we would most likely be seeing initial sell signals which will put portfolios back on a defensive posture to contain further downside risk.  If the market breaks the 50% retracement level the overall trend will be turning clearly negative and will be triggering stop loss actions.

With these new target levels in place, and assuming that the target for the S&P 500 remains at 1565, with a revised stop loss level of 1370, we can recalculate our risk/reward ratio from current levels.

Scenario 1:  Buy Now

• Reward to 1565 = 1565 ÷ 1432 – 1 = 9.28%
• Risk to 1370 = 1370 ÷ 1432 – 1 = -4.3%
• Risk/Reward Ratio = 2.15:1

Scenario 2: Buy at 1395

• Reward to 1565 = 1565 ÷ 1395 -1 = 12.18%
• Risk to 1370 = 1370 ÷ 1395 – 1 = -1.8%
• Risk/Reward Ratio = 6.76:1

Scenario 3: Buy at 1370

• Reward to 1565 = 1565 ÷ 1370 – 1 = 14.23%
• Risk to 1370 = 1370 ÷ 1370 – 1 = 0%
• Risk/Reward Ratio = 14.23:1

As you can see since the beginning of September the reward to risk parameters have improved markedly.  It is always amazing to me that as the markets rise the media and analysts continue to push investors into the market as RISK increases.  However, it is corrections in the market that the media should be happy about as REWARD increases as RISK is reduced.

Capital is precious, and very hard to replace, so mitigating portfolio risk, as much as possible, will enhance returns over the long term horizon of the portfolio.  Missed opportunities are easy to make up.  Lost capital – not so much.

Risks To Our View

With just about every major central bank involved in some sort of stimulative action we want to maintain a more optimistic view to the markets as we head into the seasonally strong time of year.  However, the deteriorating economic and fundamental variables are very concerning.  The recession in Europe and slowdown in China are dragging on exports, many economically sensitive companies are warning of a weaker economy in the months ahead, and end demand from consumers remains constrained.

As discussed earlier this week that deterioration in the fundamental and economic variables should concern you.  Historically, when prices have become detached from the underlying trend of earnings growth – it has normally been closer to the peak of bull market advances and not the beginning of the next upward advance.

However, from a technical perspective, the markets also exhibiting conditions that tend to coincide with market tops as well.  The chart below shows the market from a weekly perspective over the last three years.

Each time the market has reached these levels of over bought conditions in the past it has been indicative of a market topping process.

While we expect the market to benefit from the Fed’s bond buying program it is important to understand the risk of what might go wrong.  The is a very high level of complacency amongst investors in general at the moment as the common belief is that QE will drive asset prices higher, Congress will solve the debt ceiling and the U.S. can stand strong in the face of a global slowdown.  That is a pretty tall wish list and any one of those risks, much less a combination, could lead to a sharp reversion in prices.

This is why it is so very critical that we maintain stop loss levels in portfolio and are willing to take action to limit downside risk either through hedging or outright liquidations to reduce risk.  Remember, risk is only a function of how much you will lose if you are wrong

Images: Flickr (licence attribution)

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