RISK ON...RISK OFF

The SPX  was down 3.8% for the week, the DJIA -3.3% and NASDAQ -5% with Wednesday’s "gap down" testament to risk aversion,  accounting for the majority of the weeks range and damage. Call it what you may - implied easing, QE Lite, or just plain old monetizing the debt, the market and investors  were neither pleased with the Fed’s actions, nor reassured with Dr. Benanke’s downgraded assessment of the U.S. economy. 

Only the dollar, gold and treasuries, traded higher as investors seeked  safety, with the 10 YR  bond closing out the week yielding 2.67%, and the yield curve widening to almost 120 basis points. With earnings out of the way, option’s expiration, and little in the way of major economic releases next week,  we could be in store for more low volume days like today’s, as we close out the summer months.

After a  3% plus rally in the SPX the last 3 weeks of July,  and a fresh influx of capital  the first week of August, that led to a minor rally from 1088 to 1130, the “pundits” on CNBC were all calling for the next leg of the summer rally. Meanwhile, the “smart money” seized this opportunity  to unload their long positions and did not wait until Wednesday to begin. The hedge funds and institutions started  moving out of equities and into treasuries, July 27. 

While the market rallied, and  bullish sentiment swelled, institutional money was flowing out of equities. The rate-of change (ROC), and the money flow index (MFI) both fell as the market traded higher, indicating institutional selling and what may have been a “prescient” move from "risk on" to "risk off."

For now uncertainity pervades the the market. Fewer reliable investment strategies are available to investors, and asset classes with quantifiable returns-on-investment are scarce. Current market behavior and volatile movements of capital should perpetuate as money chases fewer “safe” assets, and investors capriciously switch back and forth, between risk aversion and risk taking. 

The SPX has the potential to break down to 875. However, if there were to be another "black swan" event, i.e., a significant geo-political crisis (like Israel attacking Iran) the SPX  could conceivably take out the 666 low.

Catching these moves are critical. As a result of structural changes to the global economy and global markets, mean reversion strategies are far less effective as returns now cluster around what have become fatter, larger tails.

For the last 25 years we were in an investment environment, where perceived risk was small, and actual risk was great. There was a predictable, almost "laissez faire" government policy, controlled inflation, and predictable business cycles. In order to generate alpha returns in this low volatility environment, investors used great amounts of leverage to achieve returns that were bunched around the mean.

In the current investment environment, perceived risk is great, and due to central bank accommodation, actual risk may not be as great. Increased government regulation is now de rigeuer, there is great economic uncertainty, and the potential transition to an inflationary economic cycle looms close behind. Lenders and investors will have to account for the greater uncertainty and risk, and the cost of investment financing will rise, and valuations on securities will be adjusted lower.

All these factors will serve to discourage the use of leverage and magnify the importance of "getting the tails right." Investors who don't understand the implications of these changes and adapt accordingly, will not be successful.