“Risk On” Rally – Don’t Forget The Risk Part

"Since Jan 1st of 2009, through the end of March, the stock market has risen by an astounding 67.8%. However, if we measure from the March 9, 2009 lows, the percentage gain doubles to 132% in just 48 months. With such a large gain in the financial markets we should see a commensurate indication of economic growth – right?

The reality is that after 4-Q.E. programs, a maturity extension program, bailouts of TARP, TGLP, TGLF, etc., HAMP, HARP, direct bailouts of Bear Stearns, AIG, GM, bank supports, etc., all of which total to more than $30 Trillion and counting, the economy has grown by a whopping $954.5 billion since the beginning of 2009. This equates to a whopping 7.5% growth during the same time period as the market surges by more than 100%."

"However, as shown in the chart above the Fed's monetary programs have inflated the excess reserves of the major banks by roughly 170% during the same period of time. The increases in excess reserves, which the banks can borrow for effectively zero, have been funneled directly into risky assets in order to create returns. This is why there is such a high correlation, roughly 85%, between the increase in the Fed's balance sheet and the return of the stock market."

As you can see in the chart below the correlation between the increases in the Federal Reserve's balance sheet is highly correlated to the rise in asset prices.

With the economic backdrop deteriorating, along with earnings, the divergence between asset inflation and economic fundamentals continues to widen.

Risk On

However, at the current time, there is no doubt that the "risk on" trade is in play.  Consequently, with no real threats on the short term horizon there is nothing to stop the elevation of asset prices as long as the Fed continues to inflate their balance sheet, and by extension, flood Wall Street with excess liquidity.

As I have discussed many times in the past, "risk" equates to how much you will lose when, not if, you are "wrong."   There is more than sufficient evidence that investors are pushing the limits of their "risk taking" ability from near record levels of margin debt, very high levels of complacency and historically low "junk bond" yields.  Despite much of the media commentary that says individuals are sitting out of the market – the data suggests otherwise.   The chart below shows that U.S. investors hold the highest level of equity exposure relative to other developed countries.

The point here is that eventually, and it is only a function of time, the "risk on" trade will be turned off.  Of course, for individuals, this leads to two primary questions:

1) When will a correction occur?

2) What will the magnitude of the correction be?

The question of "when" is always the most difficult to answer.  The old axiom that "…the markets can remain irrational longer than you can remain solvent" holds true in this regard.  Answering the question of when is, in reality, better left to fortune tellers and psychics.  Forecasting the future is always a dangerous endeavor. 

However, the question of "when" is valid because it is only a function of time until a correction of magnitude occurs.  The timing of the "when" is typcially when you least expect it.  This is the problem with complacency as the inflation of asset prices, and the belief that the "Fed" will continue to bail out every problem, lulls individuals into a state of lethargy.  This leads to panic selling when the reversion of fantasy to reality occurs and results in far more losses than most could ever imagine.

While I can't tell you precisely "when" a correction will occur – I can tell you is that the likelihood of a significant correction has risen tremendously in recent months.  The chart below shows the S&P 500 with the percentage deviation above and below the 50-WEEK moving average.  I use a weekly moving average to smooth out the noise of a daily average to better analyze the current trend of the market. 

While the market is currently in a very bullish trend – the deviation of the market is now 12.69% above its 50-WMA.  Historically, such levels have existed only prior to corrections.  In bull markets, as we are currently in, corrections tend to consist of a reversion back to the 50-WMA which is currently at 1448.  This would imply an 11.2% correction from the recent peak.  As long as the Federal Reserve continues to inject round after round of liquidity into the financial markets – corrections should be fairly well contained to the 50-WMA. 

However, this in no guarante of that.

Mapping The Correction

The chart below is a MONTHLY chart of the S&P 500 Index and overlaid with our primary and secondary overbought/sold indicators.

Currently, the S&P 500 is trading 2-standard deviations above the 21-month moving average which has only occurred previously near both short and intermediate term market peaks.

However, more importantly, is the top chart which is a very slow overbought/sold indicator.  As you can see this indicator is currently at extremes witnessed previously at the peak of the market in 2000 and 2008.  Historically, this peaking process can take some time to complete and, historically, it has been between 12-18 months.  The current extreme condition began roughly 12 months ago so the timing of a correction is coming closer.

To answer the second question of "what the magnitude of the correction will be?" will require a range of assumptions.   We know from the analysis above the correction from current levels back to the 50-WMA, a normal correction within a sustained bull market trend, would be roughly 11%.  However, with margin debt and leverage at very high levels, a correction could gain momentum leading to a more severe decline.

The chart below is a Fibonacci retracement of the market advance from the 2009 lows using a monthly price chart.  This analysis can help us determine levels of key support in the event of a more substantial decline.

As you can see there are three different retracement levels.  In most cases corrections tend to stay contained within the first two zones encompassing a retracement of either 38.2% or 50% of the previous advance.   In the event of a more substantial market correction, such as we saw in 2011, a decline to the first level would entail a loss of 22.5% with a decline to the second level pushing nearly a 30% loss.   Historically speaking, a correction of such magnitude would likely be tied to the onset of a recession in the economy.  This is a real, and rising, risk currently from the standpoint that we have already passed the median point of normal economic expansions.

The third level, which would entail a 36.6% loss, is a possibility given the onset of a recession coupled with some sort of financial or geopolitical risk.  This is a more remote possibility in the current environment.

While investor's, and the media, are certainly enjoying the market's ride – it is always important to remember that the "ride" eventually ends.  A loss of 22% to 30% will wipe out 2-3 years of gains and 5, or more, years of your retirement planning and preparation cycle.

You are a "saver" and not an "investor."  An investor, such as Warren Buffett, has no definitive time line on the investments he makes.  You, however, only have until you need your money to live on.  Therefore, after two previous bear markets, it is more important than ever to understand the level of risk you are undertaking in your portfolio and manage such risk accordingly. 

I concluded previously that:

"…while the markets have surged to 'all-time highs' – for the majority of Americans who have little, or no, vested interest in the financial markets their view is markedly different. While the mainstream analysts and economists keep hoping with each passing year that this will be the year the economy comes roaring back – the reality is that all the stimulus and financial support available from the Fed, and the government, can't put a broken financial transmission system back together again. Eventually, the current disconnect between the economy and the markets will merge. My bet is that such a convergence is not likely to be a pleasant one."

That position has not changed and as my partner and co-portfolio manager recently said to me:

"This market is like a line for the electric chair…you just know where in the line you stand."