The Risk Chart
One of my favorite charts is what I call, "The Risk Chart". It's simply the stock market divided by volatility. One of the reasons I like this chart is that it prices the market not in dollars but in the terms of risk. Managing out risk has been the single most important part of investing the past 10 years. I've used risk management to avoid every bubble melt down in managing my parent's net worth.
The Risk Chart is one of the tools I used to move my parents into 50% cash and some money on the short side of the market during most of 2008. And it's also, in part why their net worth went up slightly in 2008.
The other reason I like this chart is that it throws off great technical signals as it relates to buying or selling the markets. I don't use this as a short term trading tool, but more of a long term tool. And, this is not a primary, but more of a secondary or confirming technical analysis tool.
Below is the weekly chart of the Risk Chart (SP500/$VIX) and the monthly chart of the SP500.
The Sell Signal
The two charts above in combination were almost the majority of the reason I became so bearish in late 2007. The Risk Chart had been forming a broadening or wedge pattern from 1994 ending 2007. That is a significant pattern to keep an eye on, and the kind you would expect at the end of a major Elliott Wave cycle up.
At the same time all major markets on a monthly chart reflected huge bearish divergences on the RSI and MACD. Stock market indexes with bearish divergences on a monthly chart are quite rare, and should have been taken seriously. Those bearish divergences confirmed by or combined with the broadening top made in the Risk Chart made it very easy to understand there was too much risk in the market in late 2008.
The stock markets powered higher into 2008 but the Risk Chart itself made a lower high, which gave off a bearish divergence the markets were ready for a sizeable correction = Sell Signal.
Honestly, moving my parents to 50% treasuries and cash, and shorting the market in 2008 was an easy call based on the above technical analysis.
The Buy Signal
Then something interesting happened, the Risk Chart gave off a bullish divergence and a Buy Signal. Look closely at the weekly Risk Chart and the SP500 below
The Risk Chart made a higher low in March 2008 when the market put in a new price low, which gave off a bullish divergence at the same time the MACD on the SP500 provided a bullish divergence, those combined provided a very nice Buy Signal. This gave the all clear signal to re-enter the stock market.
I believe the ratio will test the 1990 lows around 10 on this current leg down. To do so, we will need to see higher $VIX levels and low stock prices. We might even test the SP500 lows of 2002 on this leg down before it is completed.
I do believe the markets will bounce and provide a possible long side trading opportunity at some point, as the risk chart is pointing to that opportunity. Markets can stay oversold far longer than expected, and patience for that bounce seems warranted. I do not view the next bounce as part of a new long term bull market cycle, but a bear mark rally. It could be quite healthy in size and possibly provide a profitable trading vehicle, as bear market bounces are typically sharp. During the expected bounce, I look for the ratio on the risk chart to top out (40-70) somewhere in the middle of the Wedge Pattern. Then I feel we will see the beginning of another sell off.
That call has turned out remarkably well, as the markets did test their 2002 lows, and patience from October 2008 was needed, and the Risk Chart tested its 1990 lows before we finally put in a bottom. And then, we got a sizeable market bounce, again as expected.
So, where are we now with the Risk Chart?
If you notice in the final part of the paragraph above I expected the Risk Chart to bounce or recover to the 40-70 range, which would support the market rally. Today the Risk Chart is at the 65 level and ironically testing the apex of the former wedge pattern, which is why I expected a bounce to the 40-70 (apex) range. It's also testing its 200 week moving average at around 70.
I also wrote that it was at this level where I expected a sell off to begin. I know with all the current market momentum that seems like going out on a ledge, but from a risk management perspective, the Risk Chart is telling us to be careful.
Currently, the risk chart if anything, is saying there is a great deal more risk in the markets for the long side, and that further upside should be limited and most likely be given back in the next leg down.
The MACD on the weekly Risk Chart is currently over bought, but not on the monthly Risk Chart (not shown). The only thing missing in the risk chart is a bearish divergence, so there is no sell signal on the Risk Chart. It doesn't have to end that way for the markets, but the last two signals ended on a divergence!
In summary the Risk Chart is for now confirming elevated risk and now is a time to implement risk management and gain protection strategies. The Risk Chart is saying expect a more significant correction in price and/or time than the smaller corrections we've had during this up leg.