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STA Risk Ratio Gives New Warning Signal

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    August 23, 2013

    In this past weekend’s missive “Analyzing The Correction” I discussed the onset of an initial“warning” signal that could translate into a full-fledged “sell signal” in the next week or so ahead.  However, more importantly, was the discussion of the composite “risk ratio” which tracks the most common measures of market sentiment.  However, before I get into that I want to address an issue relating to valuations.  My friend Cullen Roche of Pragmatic Capitalist, a daily must read, recently penned a piece on this topic stating:

    “I don’t really use any valuation metrics in my macro analysis (I find them largely unreliable for practical strategy application)…The bigger question is whether any of these metrics are actually all that useful for practical purpose.  I have my doubts.  As for ‘stocks for the long-run’, well, let’s just say I don’t have time to debunk that one here.”

    I suggest clicking the link and reading the whole piece – it is very good and is something that I strongly agree with.  Valuations are a horrible portfolio management metric in the short term and, as Cullen correctly points out, while they make for great talking points, that have little real value in shorter term portfolio management.  As I stated this past weekend:

    “This is why long term fundamental analysis of things such as book value, price-to-earnings ratios, and enterprise value are interesting subjects to discuss and debate, however, they have virtually no place in investment decision making today.

    Before you disregard that statement – let me explain. When the average holding period for an investment was 6 years on average, as it was in the late 70’s and early 80’s, fundamental analysis means a lot. This is because the holding period allowed time for the fundamental story to manifest.

    In today’s fast moving, point-and-click, casino the only thing that really matters is price momentum, trend, and deviations. With an average holding period of less than 6 MONTHS there is very little time for a valuation story to make any difference whatsoever.

    While University finance departments around the country still teach their students the portfolio theories that were born during the last secular bull market – the problem is that the market dynamics, due to high frequency trading, program trading and algorithms have changed the investment landscape. This is why, as investors, who are driven by emotional behaviors rather than logical and disciplined investment processes, continually fall victim to the boom and bust market cycles. For these emotionally driven individuals fundamental valuation studies really no longer have much of a place in portfolio selection or design.

    The sad truth is that ultimately fundamentals do matter. The problem is that by the time the fundamental story comes into play – individuals are so devastated by the market reversion that they cannot see the opportunity due to their panic to flee the market.”

    I discussed recently in “10 Investment Rules To Live By” that:

    “The best investments are generally made when going against the herd.  Selling to the ‘greedy’ and buying from the ‘fearful’ are extremely difficult things to do without a very strong investment discipline, management protocol and intestinal fortitude.  For most investors the reality is that they are inundated by “media chatter” which keeps them from making logical and intelligent investment decisions regarding their money which, unfortunately, leads to bad outcomes.”

    In order to determine the direction of the “herd” we should analyze what the herd is doing currently.  This is why price trends, deviations, momentum and sentiment measures are more important as they provide feed back of the “psychology” driving the markets.  In last week’s missive I discussed in particular the STA Risk Ratio which is a composite of some of the most widely followed measures of momentum, volatility and sentiment.  I stated:

    “The next chart is the most important. It is the composite risk ratio indicator which combines market momentum with common investor sentiment and fear gauges. The red line is the 8-week moving average of the risk ratio.”


    “What is crucially important to notice is the recent sharp decline in the risk ratio from the advancing peak in the market.   This was the same decline as what was seen in 2007 as the market advanced against deteriorating internals.”

    As stated the collapse in the risk ratio is a clear signal that something has changed in the market and that risk of a broader correction has risen sharply.  While this is only one measure of “risk” it does suggest that investors should pay closer attention to their portfolios than normal and implement some risk management practices such as we suggested this past weekend:

    “Review all holdings in the portfolio fundamentally to determine if anything has changed within the fundamental or technical storyline.

    Review each positions weight relative to the portfolio. Trim back positions, take profits, which are now portfolio overweight.

    Positions that are fundamentally broken, lagging or otherwise not performing should be sold in their entirety.  Positions that are lagging during a market rally tend to lead on a market decline.

    Do not sell winners to buy losers. Hold cash as a hedge against an impending correction.”

    There are many ways to approach portfolio management but the basic premise is that if you“don’t sell high” you don’t have any capital with which to “buy low.”  This is the most basic function of investment – yet it is the one thing that individuals fail to do.

    This is also one of the main reasons that investors so often get caught up in major market meltdowns. When markets fail to immediately adhere to the fundamental arguments about valuations and economics they become dismissed as “wrong” or that “this time is different.”  The reality is that these measures have little, if anything, to do with shorter term market movements.  This is why Keynes once stated that:

    “The markets can remain irrational longer than you can remain solvent.”

    In the short term markets can be, and do seem, to be irrational and being on the wrong side of the current short term trend can be disappointing or even devastating.  Currently, the artificial inflations have detached the market from the underlying economic and financial fundamentals.  As such, as an investment manager, I must remain invested in the markets or suffer career risk; but in the current environment it would be naive to neglect the rising risks of the technical extensions, deviations from underlying fundamentals and weakening momentum.

    However, in the long term, it is inherently important to remember that fundamentals do eventually play a crucial role which only in hindsight will become readily apparent.  Despite the ongoing central bank interventions the current market cycle will end.  The ongoing distortion between the market and the fundamentals will eventually revert which has, historically speaking, led to larger than expected reversions and outright crashes.  Yet, despite the historical record, investors continue to believe that the current cycle will continue indefinitely.  Simply put – it won’t.

    As Yogi Berra once stated:

    “You’ve got to be very careful if you don’t know where you are going, because you might not get there.”

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live
    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.