The Long And Short Of Risk-On, Risk-Off

From David Rosenberg of Gluskin Sheff

The Long And Short Of Risk-On, Risk-Off

We enjoyed a nice 13% rally (in total return terms) in the S&P 500 from the November 15th interim low through to the recent peak posted on February 19th Of this year. This was another in the long line of risk-on phases, and when the VIX index hit 12 and the share of bulls in the Investors Intelligence survey reached 55%, you knew a lot of complacency had crept back into the market. And why not? Europe was quiet and the fiscal cliff was averted.

The question now that we had the largest decline of the year on Monday followed by a recovery yesterday that did not recoup the losses is whether or not we have the conditions for a renewed risk-off environment, even for a short while. After all, in some sense we are long overdue given the length of time since the last correction during this four-year-old cyclical rally.

The last two risk-off periods were in the spring and summer of 2010 and again in the summer and fall of 2011. In 2010, we had Europe back in the news and concerns over the expiry of the Bush tax cuts ahead of the mid-term elections, so U.S. politics also got in the way, As things turned out, Europe did not blow up and not only were the Bush tax cuts extended but payroll taxes were reduced. Then in 2011, again Europe made the news just as the debt-ceiling debacle took hold in the U.S.A. Again, Europe did not blow up, thanks to Mario Draghi and the LTRO intervention, and the debt ceiling was raised at the last second and the S&P downgrade proved to be the proverbial tempest in a teapot

In both of these risk-on periods, the market followed a lengthy period of gains and moved into overbought terrain, much like the case now. And once again, Europe is back making the news — GDP downgrades, the poor LTRO repayment result by the banks, the uncertainty over the Italian election, the looming bailout for Cyprus — and in the U.S.A. it is all about the automatic spending cuts about to come our way and the March 27th deadline for the continuing resolution. And the U.S. economy, the global economy in fact, remains just as weak now as it did during those other two corrective phases in the market.

To be sure, the selloffs in those risk-off episodes were severe, even if brief, at around 20% declines from the interim peaks, but that is what it took to bring the S&P 500 to deeply oversold levels. But what is interesting is that the sectors of the market that outperformed the most in both cases were the Telecom Services, Utilities and Consumer Staples sectors. The first two are bond proxies as yields fell, and the last one is typically a good place to hide given its defensive characteristics. At the bottom of the pack each time were the Materials. Financials and Energy. We like the Basic Commodity group long-term, but for now we are very selective within the group and underweight as a firm (though our investment team believes that Suncor is a real sleeper here).

It was interesting to see that in the latest risk-on trade from mid-November to mid-February the top three sectors were Financials, Industrials and Consumer Cyclicals (the latter we are paring back on in our portfolios). It would be reasonable to therefore expect some reversal of fortunes from here if, in fact, we are back into a risk-off backdrop. In fact, the breakout of the DXY index is a deadweight drag for the export-sensitive industrials, the surge in gasoline prices is a real pinch for the consumer discretionary group, and as for Financials, relative strength has rolled over and is down now in five of the past six sessions, as is the case by the way with the RSI for the Dow Transports. and I see that commercial bank lending has declined now in five of the past six weeks and across all major lines of business (-2.7% at an annual rate for consumer credit. -3.5% apiece for residential mortgages and for commercial & industrial loans). The laggards during this roost recent risk-on environment were Telecom and Utilities — again, bond proxies and bonds have started to rally again — and Technology (question is whether this is the ‘cyclical’ to move into as a replacement for old-economy industrials and consumer discretionary which frankly, look tired here).

One thing to keep in mind that could well limit the severity of any near-term correction is the Fed. Recall that in 2010 and again in 2011. the Fed was scheduled to terminate its Quantitative Easing programs and this aggravated the selloff. So after crying ‘uncle’ twice to stem the market’s decline and extending QE, the Fed late last year introduced perpetual QE — and Bernanke yesterday gave no sign at all that he is about to back away from the program. He doesn’t see bubbles forming: and if he did, he made it quite clear that the dual mandate of full employment (not there with a U6 rate over 14%) and price stability (in the current case, preventing deflation) would still take precedence. I have long cited the 85% correlation between the Fed’s balance sheet and the market’s direction over the past four years — the extent to which the laws of diminishing returns begin to set in will be interesting to see, me-thinks, over the next several weeks and months.

Zero Hedge

The Long And Short Of Risk-On, Risk-Off