Thursday, May 24, 2012

Sentiment Indicators say the Markets are in HIGH RISK mode

Our Sentiment Indicator declined to 4 in February 2012.  This means the markets (including equities, corporate bonds, Fx, etc) are not considering the embedded risks.  For exampl, Banks are lending to companies with Covenant-lite loan structures.  Investors are buying bonds without demanding large premiums or spreads over treasuries, etc. Thus, this is Bearish, but note this is not a (short-term) timing index.

Since Feb'12, the Sentiment Indicator has moved slightly higher.  This is a normal movement, but we still consider the Markets in a high risk phase.

Macroeconomic backdrop:

The European Crises is likely to improve over the next few weeks.  However, unless a EuroBond (bonds backed by the Euro-zone countries) is implemented the Euro-Crises will return with a vengeance.  A EuroBond is a low probability solution given that the Germans want the weaker Eurozone members, such as Greece, to execute on their promised Austerity Plans.  This probably won't occur given the political instability in Greece and upcoming (June) elections.  Other Euro-zone countries (i.e., Spain, Italy) have the same issues.

The "Eur-Lema":
Europe is in a tough dilemma:  If it enacts Austerity Measures, economic growth will deepen the Recession (see Purchasing Manager's chart below).  If (French president) Hollande's growth-friendly agenda is supported in the Euzo-zone, Debt levels will continue rising, in turn causing funding rates to soar.  There is no easy solution!

Likely temporary measures:  We expect the European Central Bank to command a big part of a short-term "bandage" by:
  1. lowering interest rates,
  2.  supporting banks by lending to troubled ones,
  3.  and outright purchasing of bonds on the open market.
Source: Markit Economics

Sentiment Chart:  It became bullish when the index surpassed 7 in mid-August'11.  Since then, it has trended lower to the recent low of 4 during Feb'12.  That was the lowest since July'11. <click chart to enlarge>

Technical Chart.  It became extremely Bullish in August'11 as well, but moved to Neutral in Feb-April 2012.  <Click chart to enlarge>

As a long-term investor, I believe the time for Socially Responsible Investing is now…right NOW.  Long-term investors are not concerned over the current level of the stock market and whether the Market’s 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 anyone?).

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.

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. 

This website will 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.

Helios and Matheson: I’ve seen this movie before, and it ends badly !

Summary:   My career as a penny-stock equity analyst gives a unique perspective to the issuer  HMNY is insolvent and the likeli...