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You say goodbye and I say hello, Another look at an old friend: Risk

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June 24, 2010 – Comments (16)

Over a month ago I wrote this post: A look at an old friend: Risk - http://caps.fool.com/Blogs/a-look-at-an-old-friend-risk/392209 and had this to say:

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.


Here was the chart from that time:



ENLARGE

The market continues to break down and we have several bearish developments

1) Volume on the down moves are *much higher* than the volume corrective rallies back up
2) Many, if not the majority, of major indices (international and domestic) have been making lower highs and lower lows for the past few months
3) Many of the US indices have closed below their 200 day MAs for weeks
4) Last week on a break back above the 200 day MA, it tested the 50 day MA from underneath *and failed* (this is quite bearish). This is true for the SPX, INDU, NYA, RUT, COMPQ, and NDX
5) Many ETFs are showing death crosses (50 day MA below the 200 day MA) but we now have a major US index showing the same behavior: The NYSE Composite (NYA)
6) Many international indices are showing the same behavior: CAC 40, IBEX, NIKKEI, SSEC (Shanghai), HSI, etc. The are not small indices, this is a big deal

I could point to a whole host of fundamental factors as well, but those are well-documented in my Caps blog. The real point is to show that we are in the midst of a trend change. Does that mean we go into crash mode? Maybe, maybe not. But I think this is a possibility you should be cognizant of and at least prepare for in the way of reducing exposure to risky issues.

At any rate, here is my updated risk chart. It is saying that risk is most definitely increasing



ENLARGE

16 Comments – Post Your Own

#1) On June 24, 2010 at 7:44 PM, ralphmachio (25.37) wrote:

Do you think it will be more profitable to hold gold or short the market?

I personally have been getting a tremendous education in the last 4 months as a day trader. I have gone from becoming a depressed lush, to thinking I was invincable, to "I really wish someone would have told me to quit while I was ahead, and not use 4x leverage on every trade", to well, at least I'm above even, and got one hell of an education, and can at least make a living if I am not too greedy, particularly in sideways markets.  I also learned to be careful shorting gold miners...

I hope I am not being too bold holding a little FAS overnight as a contrarian short term play.  I agree with you, the long-term prospect for the market is down, medium term as well, but could we see one last annoying bounce? 

 

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#2) On June 24, 2010 at 8:36 PM, Griffin416 (99.98) wrote:

Nice find! I have never seen this ratio before and makes total sense. I think I just soiled myself with bearishness, I will definetly lighten up when the VIX goes back to the low 20's (a quick relief rally.

In case you haven't seen other cool ratios I give you this page http://www.investmenttools.com/futures/metals/welcome_to_the_page_about_gold.htm

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#3) On June 24, 2010 at 9:29 PM, binve (< 20) wrote:

ralphmachio ,

Hey man!

>>Do you think it will be more profitable to hold gold or short the market?

I think holding gold will be the most profitable, but the question goes to timeframe / risk / management, etc. Gold is something that I "buy and forget" for a few year. I don't manage my gold positions, I don't trade gold, I just buy pullbacks. That is the no-brainer approach to investing for the next crisis.

But swing trading the Wave 3's down (Minor, Intermediate and Primary) will be profitable. But they require a lot more management / watching indicators / reading waves / doing analysis / etc. They require much more involvement and are therefore much riskier. But the *short term* rewards are greater.

That is why I take both approaches. But by far my biggest positions are just gold positions. There is nothing I am more bullish on.

>>at least I'm above even, and got one hell of an education, and can at least make a living if I am not too greedy, particularly in sideways markets.

Amen!

>>I also learned to be careful shorting gold miners...

Good call :)

Thanks for the comments and questions!

Griffin416 ,

Thank Griffin!

>>I will definetly lighten up when the VIX goes back to the low 20's (a quick relief rally.

Actually, you may want to check out this post of mine (go to the bottom where I discuss the VIX), if (and it is a big if) my prediction is right, the VIX will be trending higher for awhile: Falling

>>In case you haven't seen other cool ratios I give you this page http://www.investmenttools.com/futures/metals/welcome_to_the_page_about_gold.htm

Right on! I will check them out. Thanks!!..

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#4) On June 24, 2010 at 11:43 PM, Tastylunch (29.29) wrote:

hey Binve

Look at Oil lately TA wise?

Given the whole BP situation, drilling ban etc.I think we may be in a major eye of the storm in Oil.

I'd have to think supply ought to be a problem here relatively soon.

we got a  death cross in progress on west texas intermediate, but I'm more interested  in the next bottom. Since I think it may be the last good shot at getting in before the express train to 100+

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#5) On June 24, 2010 at 11:52 PM, binve (< 20) wrote:

Tastylunch ,

Hey man!

Here is my short term oil chart, it does not look bullish. For the short term (next couple of months) it looks like it wants to pullback. We have a large wedge formation, the OVX is breaking out to the upside, and the stochastics are turning down from overbought, the daily chart does not look bullish for the short term IMO



ENLARGE

>>we got a  death cross in progress on west texas intermediate, but I'm more interested  in the next bottom. Since I think it may be the last good shot at getting in before the express train to 100+

I agree, the death cross is another bad short term omen. But we have some solid support at 50-60 and we have trendline support down there was well. If I had to guess, that would be my downside target.

I am still bullish on oil long term, as we have talked about. That position of mine has not changed. A pullback to there I would view as a nice buying opportunity

Thanks man!..

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#6) On June 25, 2010 at 12:04 AM, Tastylunch (29.29) wrote:

Yeah I was thinking more along the 12-24 outlook, not this summer really.

55 is my target area for a pullback as well... Looks like you have multiple supports there.

at least to my POV the upside downside ratio for Oil looks more attractive than Gold as a trade at the moment.

course I view Gold more as insurance than a way to make money anyway.So it's not really a valid comaprison.

thanks man, same page again. heh uh oh.

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#7) On June 25, 2010 at 2:47 AM, Tastylunch (29.29) wrote:

re: Oil supply

http://www.theenergywatch.com/2010/06/24/343/

Jim Rogers is bullish too. But that's not a surprise.

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#8) On June 25, 2010 at 8:30 AM, binve (< 20) wrote:

Tastylunch,

>>55 is my target area for a pullback as well... Looks like you have multiple supports there.

I totally agree

>>thanks man, same page again. heh uh oh.

ruhh rohh :)

>>re: Oil supplyhttp://www.theenergywatch.com/2010/06/24/343/ Jim Rogers is bullish too. But that's not a surprise.

Thanks! I agree, not a surprise :) Thanks man!..

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#9) On June 25, 2010 at 10:01 AM, Griffin416 (99.98) wrote:

Binve, geez you really know how to rip a bull's heart out, huh? I wish you would post more chart like these, with MA, trend lines and wedges, something everybody can understand. the waves just confuse me. Thank you for your posts.

I'm a big believer in higher oil, considering gold is going higher and there is a definite correlation/ ratio between gold and oil. Big question here is how to play it. OIH sucks, big oil doesn't keep up, USO loses because of the rollover costs. Best way?? RSX? How you guys play it?

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#10) On June 25, 2010 at 10:23 AM, binve (< 20) wrote:

Griffin416 ,

Hey man!

>>Binve, geez you really know how to rip a bull's heart out, huh?

Sorry man :( But I just gotta post them like I see them.

>>I wish you would post more chart like these, with MA, trend lines and wedges, something everybody can understand. the waves just confuse me. Thank you for your posts.

Thanks man! Yeah, I do quite a lot of tradtional TA but I always use them in conjunction with wave counts

>>I'm a big believer in higher oil,

Me too, definitely

>> Big question here is how to play it. OIH sucks, big oil doesn't keep up, USO loses because of the rollover costs. Best way?? RSX? How you guys play it?

Yeah, it is a very tough question. USO does suck (1 month rollover). USL is better (12 month forward rollover = better tracking) but as you can see from the pink line above, even it has tracked dismally. But short of actually playing oil futures, I like USL the best. Of all the producers, I still like COP the best. I have held it for years, good but not great dividend, and I really like the reasearch and money that they have put into alternative energy. I do think triple digit oil is a very real possibility with a faltering economony due to bad economic and monetary policy, and I am a big believer in alternative energy. Hydro and geothermal is my favorite and thin film solar (when it matures) is another favorite. But solar thermal is very near and dear to my heart: (Here is a very old post I wrote on it: http://caps.fool.com/Blogs/investing-in-solar-thermal/57086). Much of these arenas are not investible yet, but they will be in the next 2-3 years IMO. Thanks!..

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#11) On June 25, 2010 at 11:16 AM, outoffocus (23.09) wrote:

Yeah, it is a very tough question. USO does suck (1 month rollover).

When I wanted to invest in oil I invested in DBO and it turned out to be a good investment. I have since sold out of it but my CAPS pick is open and still positive. Its worth checking out.

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#12) On June 25, 2010 at 11:38 AM, binve (< 20) wrote:

outoffocus,

Yep! I agree, another good option. DBO and USL track oil pretty equally, and both do a better job then USO. Thanks!..

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#13) On June 25, 2010 at 2:29 PM, Tastylunch (29.29) wrote:

Griffin416 

I usually look for equities that  have the most levered exposure to longside. I'm  researching that now.

I'll usually try to pair with a strong FA sound player from the sector as well.

 In oil's case I think one needs to be careful, a lot of the majors have major behind the scenes problems that the market hasn't noticed yet. There is a reason Chanos is short XOM and Shell. And it's because they are having expend rapidly growing amounts of FCF to find replacement wells. The cost of drilling is sky rocketing and the output of new finds is declining rapidly compared to the cost.

It may be that the service sector plays, like a Schlumberger etc might be safer than the actual producers themselves.

Not really a fan of the ETFs for anything other than daytrades. too many tracking errors.

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#14) On June 25, 2010 at 5:45 PM, obsoleteaccount (20.63) wrote:

Question, does increasing oil prices hurt companies like Transocean since they dont sell the oil, or does it help because they can raise drilling prices? I know VLO tends to move inversly to oil prices since it refines it.

Also a basic question of economics ive had trouble with...when supply goes down, price goes up.  How is this necessarily a good thing?  If you have one barrel of oil to sell for $100, or three to sell for $75, youre making more by selling three of them for less.  Is it because the operating costs are the same for both so the higher profit margin overrides the increase in revenue?

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#15) On June 25, 2010 at 8:46 PM, FreeMortal (29.34) wrote:

Some Interesting stuff.  Binve, what is your opinion of the Ned Davis Research (NDR) Crowd Sentiment Poll?  Its currently reading well into the pessimism zone.  (along with other sentiment indicators found in the schwab market report

Now (assuming your data and theirs are pretty accurate) why would low optimism pair up with small cap buying?  The carry trade comes to mind.  Who is buying these small caps?  I'd like to see a chart of institutional ownership over time.

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#16) On June 25, 2010 at 10:31 PM, Tastylunch (29.29) wrote:

, Valyoo

Oil price helps Transocean. Why? because it makes previously uneconomical deepwater projects possible. So they get more jobs from the majors.

Transocean and the services guys make money off what I call "tough oil" jobs. When oIl is below 75 a lot of things pertaining to their expertise don't get greenlighted by Exxon etc.

>>How is this necessarily a good thing?

It's not at all if you are a net user of Oil. It drives up the cost of living in just about everything and there is a very strong correlation between high oil prices and recessions in the US.

However If you are a net exporter (seller) like Brazil or an Oil producing company it's gangbusters.

>>If you have one barrel of oil to sell for $100, or three to sell for $75, youre making more by selling three of them for less.

Depends on whether your costs are fixed or not (and also most critically who the "you" in the example is) Say Exxon's cost is 65 per barrel and that's fixed, then selling one barrel at 100 makes XOM 35 gross where selling three at 75 makes XOM 30...

so it depends entirely on whether the costs are fixed or not. In oil it's almost always not. E.g. land oil is cheaper to extract that ocean. Deepwater is more expensive than shallow. And Tar Sands may be the most expensive of all.

just depends it's not a clear cut answer for most players.

Of course it depends on who the "you" is. e.g. If "you" are a pipeline operator or a gas station you don't care much about price. What you make money by is volume, since your margins are more or less fixed.

a gas station is probably going to gross ~5% on fuel whether gas is 2.00 per gallon or 4.00. obviously 5% of 4.00 is better than 2, but if your volume drops off a ton it's not good.

e.g. if gas station sells

1000 gallons at 2.00

or 400 gallons at 4.00 ,

 you better believe the gas station would prefer the first situation. Especially when you consider that most gas stations make their money off snacks and less gas sold means less oportunities to sell Cokes, smokes and beer

 

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