Collapse of Risk Ratio Is Worrisome – Here’s What It Means & What Action You Should Take

The collapse in the STA Risk Ratio, which tracks the most common measures of market sentiment, 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.

So writes Lance Roberts (streettalklive.com) in edited excerpts from his original article* entitled STA Risk Ratio Gives Warning Signal.

[The following article is presented by  Lorimer Wilson, editor of www.FinancialArticleSummariesToday.com and www.munKNEE.com and the FREE Market Intelligence Report newsletter (sample here – register here) and may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.]

Roberts goes on to say in further edited, and in some places perhaps paraphrased, excerpts:

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:

1. “Review all holdings in the portfolio fundamentally to determine if anything has changed within the fundamental or technical storyline.
2. Review each positions weight relative to the portfolio. Trim back positions, take profits, which are now portfolio overweight.
3. 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.
4. 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. 

Unfortunately, despite the historical record, investors continue to believe that the current cycle will continue indefinitely.  Simply put – it won’t…

[Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.]

*http://www.streettalklive.com/daily-x-change/1796-sta-risk-ratio-gives-warning-signal.html

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