Market Indicators Turning Bearish, Signaling High Risk Environment

by: Dominic Lombardo, CFA, FRM

While I advocate always being invested in the market (see background information below), duly note that my Sentiment Indicators are now saying we're in a very high risk environment.

Though, as I'm writing this, markets, both here and abroad, are up in overnight trading after hearing the great earnings releases from mega-techs Apple (NASDAQ:AAPL) and IBM (NYSE:IBM) and growing comfort over European Union support of PIGS (Portugal, Ireland, Greece and Spain, etc.)

What does this mean?

Essentially, investors are not adequately being compensated for all the risk they're taking in equity, as well as bond markets (e.g., lower corporate bond spreads). There is a high probability of a sudden, unexpected correction in capital markets over the next month.

Conclusion: Now ... right now ... would be an opportune time to take profits.

What people are saying: "You know, so many people are telling me that they're earning little, if any in their bank. And so, they have to invest in stocks and bonds." My answer is this, "No one's twisting your arm", "There's nothing wrong with keeping some of your assets in zero-yielding money markets." Don't listen to what your friends are doing folks, do what you think makes good sense.

The chart below shows the Sentiment Indicator going back from 2005 to the present day. As you can see, it's not perfect, but does do a decent job at showing market tops. The Sentiment Indicator has been back-tested, by hand, for reliability. Data goes back to 1992/93.

Sentiment Indicator: Historical Chart vs. S&P500 Index

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The table below shows the results of my back-testing. Highest accuracy was in the T1 (one month time period) after the Sentiment Indicator gave a High Risk/Bearish Signal (which would be a lower number, e.g., below 4.0). Average subsequent S&P 500 loss was 2%.

I refined the accuracy/predictive power of the Sentiment Indicator by examining at (and from) what levels it worked best. When the Sentiment Indicator is well-below its recent peak, the Sentiment Indicator works best. The most recent signal (1/2011), and two previous: 1/2010 and 4/2010, have followed the above trend. This raises my confidence level in the implications of the current reading.

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Background Information

As a long-term investor, I believe the time for socially responsible investing is now. Long-term investors are not concerned over the current level of the stock market and whether the market is going to rise or fall the next day.

I propose investors be “fully invested” in equities most of the time. Being “fully-invested” is different for different people depending on age, risk tolerance, etc. As a Heuristic, I suggest being 75% long equities as a “base-case” level. The remainder would be invested in bonds, real-estate, hard assets and alternative/exotic investments (e.g., natural gas, platinum, rare-earth).

With that being said, there are certain times that are better to invest in the market. Rather than choosing tops and bottoms based on certain fundamental criteria (e.g. price to earnings ratio), I have developed two Market Timing Indicators. These indicators help me maintain objectivity with regards to my investment positions, as I have no influence on them. They were designed during late 1992 and have been updated weekly since.

The two major indicators are:

1. Sentiment: Based on human behavior, and supported by theories backed by Behavioral Finance.

2. Technical: Which measures market breadth, or underlying strength in the broad market. This indicator was Neutral-Slightly Negative as of 1/2011.

These indicators are used to obtain my portfolio's investment position. Note, they do not know, or represent market levels. They are measures of perceived risk, especially the Sentiment Indicators. I have often taken mental notes of how everyone seems to clamor to buy things when their expected rate of returns are minimal compared to their inherent risks.

I include three simple colored (traffic) signals. Green for “Buy” (i.e, low-risk levels) which means allocate your portfolio to a fully-invested equity position. For me, that’s about 75-80% invested, but it could be lower for a more-risk adverse, or retired individual. Yellow, means caution, risk levels rising. Red means “High-Risk”; investors should reduce their investment positions to conservative levels, perhaps 30-40% equity. The remainder could be in treasuries, gold, high-grade corporate bonds, etc.

Disclosure: I am long GMCR, IFSIA.