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As December Unfolds, Keep Watching Key Risk Indicators

Avoid trader tunnel vision by examining indicators still in the "danger" zone

Holiday weeks can be erratic. But with last week’s 1% gain in the S&P 500, it was another win for the bulls.

Source: Shutterstock

Before Thanksgiving, investors were willing to send the major indexes to new highs on hopes that the U.S. and China were making some concrete progress in the trade negotiations. So far, the phase-one trade deal is mostly just talks.

News Tuesday that the deal could extend beyond the 2020 presidential election sent stocks falling, but by Wednesday morning, President Donald Trump had changed his tune once again.

If that still sounds like there is a lot of uncertainty left — we agree — but it’s better than what we have seen over the last two years.

Rather than trade, an ebbing of most market risk indicators has contributed to our recent short-term optimism. These signals include:

  1. A divergence between value stock and growth stock performance has resolved, which we discussed our last update.
  2. All the major market volatility indexes are low.
  3. Currency markets are sanguine despite growth concerns in emerging markets.
  4. The Treasury yield curve remains in positive territory despite pulling back a little over the last few weeks.
  5. Valuations are high, but they aren’t as high as they were in 2017 and 2015, which indicates a lower potential for a bubble.

These are all real positives, and they are the reasons we have been very reluctant to reduce the size of our recommended portfolio. For now, we think taking advantage of the bullish trend is the best short-term strategy.

However, all this bullishness should make us ask, what risk indicators are still in “danger” territory?

Evaluating these other measures is a good exercise to make sure we don’t get “trader tunnel vision.” These are also good indicators to watch in order to justify expanding our bullish positions as the indicators improve.

Long-Term Treasury Bonds

Source: Source: Chart by TradingView

Despite the new records in stock prices, long-term bonds are also racing higher. That is unusual because generally the two asset classes have a strong, negative correlation in the short term. If investors want stocks, they sell bonds and vice versa. The last time the two assets were trending together was in July 2019, just before the market selloff.

Back in July, we pointed this out as a potential harbinger of risk that investors should watch. That warning turned out to be well timed, and we were able to take advantage of some nice opportunities when the market bottomed out in the fall.

The recent trend in bonds is worth watching for the same reasons, but we aren’t as concerned as we were earlier this year. There is good reason to assume this correlation is the result of investors anticipating an overly active Federal Reserve.


Source: Source: Chart by TradingView

We have mentioned this indicator a few times in the weekly updates because non-professionals often overlook it.

The CBOE SKEW index, also known as the SKEW, measures option prices on the S&P 500 and can detect when investors are buying put options as a form of “insurance” against declines in the market. If the SKEW is high at the same time the market is at new highs, it indicates that risk is elevated.

As you can see in the following chart, the SKEW has been rising with the S&P 500. It did something similar before the May and July declines earlier this year.

The SKEW often becomes a sort of self-fulfilling prophecy. If investors fear a decline, they buy put options as insurance. If that cycle continues, investors are more and more anxious to find an exit to keep their profits.

Japanese Yen

Source: Source: Chart by TradingView

Earlier in the update, we mentioned that the currency markets have mostly calmed down, which is important for global growth. However, the Japanese yen is a critical asset to watch for reasons beyond whether volatility is rising or falling.

The yen is a safe-haven investment for businesses in Asia and the Pacific Rim. So when it rallies against the dollar, it is often an indicator of stress and pessimism among investors. The Swiss franc plays a similar role in Europe.

The fact that the yen has not been moving higher against most of the other major currencies despite civil unrest in Hong Kong and weak economic data from China is a good sign about investor sentiment.

However, the USDJPY exchange rate continues to resist fully breaking out of its inverted “head-and-shoulders” pattern that formed earlier this year. When risk appetite increases, investors like to use the yen as a source of funds. Borrowing the yen for asset purchases is like shorting the yen itself. That puts pressure on the USDJPY to the upside which is what we want to see.

Our studies of this technical pattern comply with others done by analysts, including the New York Federal Reserve. After the pattern appears, a breakout is very likely within 45 days. In this case, that would be around the second week of December this year.

We may want to take advantage of such a breakout with an option position on a currency fund or a stock with exposure to Japan and China.

The Bottom Line

As we mentioned in our last update, although valuations are high and there is some mixed data internationally, we are still cautiously optimistic about the market in the short term. We recommend watching some of the key risk indicators that could trigger a more aggressive stance in December.

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