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A look at an old friend: Risk

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May 16, 2010 – Comments (10)

There are many ways that we measure "risk" in the market. Most of it is actually not risk, but measures of volatility that people ascribe to risk. But things like the Beta and trends in the VIX are used to describe the risk environment (the volatility environment). I have talked about the VIX many times (such as Impressive VIX and VIX-Sentiment). And I am interested in another topic today.

Equity Risk

Looking at the movement of Small Caps relative to Large Caps can be very informative. Small Caps are much more volatile and during the good times can juice your returns (and during the bad times can crash like, well ... small caps during 2008).

But these moves are based on herd behavior. The herd is always very bullish at market peaks and very bearish at bottoms. So looking at when Small Caps are richly valued relative to Large Caps describes when bullishness becomes uber-bullishness and can be the precursor to a trend change. This is another indirect sentiment measure that I like.

In particular, when I look back over the last few years, the ratio of the Dow Industrials to the Russell 2000 reaches a certain level when trend changes occur. The ratio is at that same level currently. And the market is saying "I AM SUPER BULLISH!!!". Lots of talk about going to new highs is funneling money into more speculative issues, like junk bonds, homebuilders and yes small caps.

Which says to me: The risk environment is extreme.

Good luck out there.



ENLARGE

10 Comments – Post Your Own

#1) On May 16, 2010 at 1:46 AM, uclayoda87 (29.36) wrote:

Binve - 

What I suspect that you are seeing with the rise in small cap stock investments is the effective advertising that has been fed to the public by most of the major media.  Up until recently, most of these “news” organizations have been telling us that we are in the early stage of a recovery and a real bull market, which is generally when you would expect the small caps to outperform.  So it is not surprising that the herd has made this bet.  With the recent financial news, I suspect that after the next crash the herd will be directed into the US bond market, just in time to get slaughtered by the expected rise in interest rates.

 

More conspiracy theory, I know!

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#2) On May 16, 2010 at 2:00 AM, Beorn10 (29.99) wrote:

Maybe you don't give these investors enough credit, aren't many of those high-flying Canadian miners small cap stocks?

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#3) On May 16, 2010 at 2:34 AM, SamTheHobbit (30.02) wrote:

Good luck out there.

Should be:  Let's be careful out there.

 

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#4) On May 16, 2010 at 3:58 AM, djshagggyd (74.19) wrote:

Great post binve! 

When Small Caps are richly valued relative to Large Caps describes when bullishness becomes uber-bullishness and can be the precursor to a trend change. 

I'm still new at this, but what you're saying sounds very logical and makes a lot of sense to me. Thanks for sharing.

~djshagggyd 

 

 

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#5) On May 16, 2010 at 10:04 AM, amassafortune (29.62) wrote:

It is amazing that the U.S. market has defied gravity in 2010 after being catapulted by liquidity in 2009. The stimulus itself was an infusion of risk, not much different than individuals who are paying credit card mins with other cards. All appears prosperous until the first payment is missed.

Solid earnings, especially by larger companies (highlighted by your graph) and the fact that almost the entire world has been as reckless with debt as the U.S., make the U.S. market appear more stable in comparison. Many European countries do not need to properly account for long-term debt obligations in their current budgets. This is one reason why Greece, Spain, Portugal, and now the U.K. debt situations only hit the news a few months ago, but are already having a market-moving effect.  

In the U.S., even the huge underfunding of public employee pension plans and commercial real estate Alt-A and option ARM loan rate resets have not scared investors. 20% unemployment continues to be dismissed as a lagging indicator.

Us early bears understand the risk environment is extreme and has been for a long time. I think the jig is about up, but as long as the Fed can funnel newly-printed money through giveaway programs like the census, the herd may continue to accept risk. May could be the turning point. By early June, monthly statements are likely to show that all 2010 gains have disappeared. As in September 2008, this will be the point at which the herd understands the current risk environment - the point of recognition.

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#6) On May 16, 2010 at 10:49 AM, binve (< 20) wrote:

uclayoda87 ,

>>More conspiracy theory, I know!

Well then consider me a conspiracy theorist because that made sense to me :) Thanks man!

Beorn10 ,

LOL! Actually in the Russell 2000, no. But the CDNX is. And it looks to be stronger recently than a lot of other indices.

SamTheHobbit,

Nice :)

djshagggyd ,

Thanks! no problem!

amassafortune ,

Hey amass!

>>It is amazing that the U.S. market has defied gravity in 2010 after being catapulted by liquidity in 2009. The stimulus itself was an infusion of risk, not much different than individuals who are paying credit card mins with other cards. All appears prosperous until the first payment is missed.

Exactly. Similary analagoy can be made by allowing Greece into the EU. Everything is fine. Feed them more debt than they can afford to ever pay off. Because those parties are not interested in getting paid off, they just want the debt rolled over indefinitely to collect interest. But as soon as the hint of an interest payment being missed appears the game is up.

>>In the U.S., even the huge underfunding of public employee pension plans and commercial real estate Alt-A and option ARM loan rate resets have not scared investors. 20% unemployment continues to be dismissed as a lagging indicator.

LOL! I know. (fingers in ears: la la la!!)

>>Us early bears understand the risk environment is extreme and has been for a long time. I think the jig is about up, but as long as the Fed can funnel newly-printed money through giveaway programs like the census, the herd may continue to accept risk. May could be the turning point. By early June, monthly statements are likely to show that all 2010 gains have disappeared. As in September 2008, this will be the point at which the herd understands the current risk environment - the point of recognition.

Yep. I agree. This latest development has sowed some doubt. I think investors are getting really nervous for the first time in a year and a half. Thanks man!..

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#7) On May 16, 2010 at 11:21 AM, portefeuille (99.60) wrote:

Similary analagoy can be made by allowing Greece into the EU.

http://en.wikipedia.org/wiki/European_Union

http://en.wikipedia.org/wiki/Eurozone

http://en.wikipedia.org/wiki/Greece

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#8) On May 16, 2010 at 11:22 AM, portefeuille (99.60) wrote:

Us early bears understand ...

good old bears ...

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#9) On May 16, 2010 at 12:37 PM, amassafortune (29.62) wrote:

port, my advice to my children and to anyone under 30 is to hold blue chip longs and growth companies, continue to buy selectively and plan to buy heavily if the double-dip happens. Continue to contribute to your 401K at least to the company matching level. I myself held steady and bought through the crash 1987 and 91-92. I did sell some around March 2000 which kept my total return that year at -1%. Then I was a buy and holder again until late 2008. 

I have seen your green DNA graph and think it is a good, instructive chart for anyone in their wealth-building phase. Your concentration on growth and biotech are also a relatively safe place to be. The DAX will outperform the S&P for several years. Germany will be the first to pull out of the EU and save its citizens some tax burden. It will be very rewarding if my children follow your bullish model. If we get a deep correction, it may be the best investing climate of their lives. 

For me, though, a deep correction can easily equal many years of schlepping off to work - an activity not suited for extended periods of deja vu. I have made it once and if we have a recovery that looks like Japan's, I may not have time to make it again.

I wear a helmet. I wear a seatbelt. When a fire alarm sounds, I head for the exits. I don't care that the building was designed to contain the blaze floors above. I don't care that an expert's assurences I understand that lobbyists are not employed to ensure that the elected are squeezing the greatest good out of taxes for the greatest number. I consider the bearish scenario because of the political/financial power shift and levels of worldwide debt. The avoidance of loss exceeds the promise of gains at this time in my life. I am a good old bear and periods hibernation are instinctive.  

 

 

 

 

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#10) On May 16, 2010 at 5:38 PM, dwot (60.71) wrote:

Lol, I look back at the stuff I was vested in, and risk is an understatement.  I was looking at a lot of smaller caps and the numbers were easy to look good, but many ran into huge problems with the crash and a lot of the numbers they gave turned out to be very wrong and highly optimistic.

 

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