May 17, 2014

4 Possible Macroeconomic Signals of a Market Correction

In March 2012, I took a defensive position, the stock market went on to correct 10 percent two months later.

In March 2013, I moved most of the position out of Asia and took a sizable position in cash, the Asian Markets crashed more than 10 percent in May 2013.

Many people were asking me what are some of the Macroeconomic indicators that I look out for to judge when the stock markets are ripe for a correction. I think the current environment we are in will make a very interesting case studies. Let's look at some of the signals and clues that the markets are flashing right now. 

 VIX: The Greed & Fear Indicator

VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period.

In summary, the lower VIX is, the more complacent traders are. The higher the VIX is, the more fearful traders are. In the past few years, major market corrections are always proceeded by VIX index falling to 12 points. The last time it happened, global markets corrected almost 10% in Jan. However, the correction was short lived and the stock markets have been trending sideways since than. It is until recently, the VIX index hit 12 again....



Baltic Goods Index
The Baltic Dry Index (BDI) is a number (in USD) issued daily by the London-based Baltic Exchange. Not restricted to Baltic Sea countries, the index provides "an assessment of the price of moving the major raw materials by sea.

Other leading economic indicators—which serve as the foundation of important political and economic decisions—are often measured to serve narrow interests, and subjected to adjustments or revisions. Payroll or employment numbers are often estimates; consumer confidence appears to measure nothing more than sentiment, often with no link to actual consumer behavior; gross national product figures are consistently revised, and so forth. Unlike stock and bond markets, the BDI "is totally devoid of speculative content," says Howard Simons, an economist and columnist at TheStreet.com. "People don't book freighters unless they have cargo to move."

Although not as strong indicator as VIX due to the high percentage of speculators in the stock markets, the BDI gives a good indication of the overall fundamental health of the global economy. BDI is a better prediction for major economic recessions than the minor yearly market corrections. I use the BDI to judge how much defensive I will become, when a potential correction/market crash is imminent. The BDI has fallen sharply since Jan and at one point of time, fell below 1000 in April before recovering slightly. The last time it fell so low, was in April 2012, which was just one month before the stock markets in the Emerging Markets crashed.

10 years US bond yield
When the Big Boys are fearful, they tend to rotate their portfolio into US treasuries, and normally into the longer period US treasuries. Typically, the longer the period (10-30years) the more sensitive the price of US treasuries will be as compared to the degree of movement of the stock market. This means that, when the yield of the longer term US treasuries start to fall, it indicates that the Big Boys are buying into market insurance, anticipating a possible stock market correction in the future. A more extreme indicator of a possible massive market crash is the inverted yield curve, which occurred in 2006, just before the 2007 global financial crisis.

In recent weeks, the yields of 10-30 years US treasuries have been coming down, while the short term yields have been inching up, leading to a flattening of the yield curve. It does mean that the Big Boys are accumulating on the longer term US treasuries, but what are they anticipating? The answers will probably be revealed in weeks to come.  

Divergence of Russell 2000 vs S&P500
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.The Russell 2000 is by far the most common benchmark for mutual funds that identify themselves as "small-cap", while the S&P 500 index is used primarily for large capitalization stocks. It is the most widely quoted measure of the overall performance of the small-cap to mid-cap company shares.

In a typical risk reward scenario, the higher risk small cap stocks will outperform the more stable big cap stocks which consist of multinational corporations. Therefore, investors will tend to sell their higher risk assets and keep their lower risk assets whenever they believe that the stock market is about to fall. The Russell 2000 has been trending downwards in the past few weeks, even though the S&P500 has been trending upwards. This is another fishy trend... 



Summary

Most retail investors are often the last people to get out, when the financial markets crash. This is because, they are often reactive, rather than preemptive. Many investors are searching for the holy grail of predicting the future, to avoid the next market crash, but they are often caught in the giddiness of profit making that they forgot about their search. There are also investors who just do not know where to look. Hopefully, this articles will shed some light, on what are some of the signs professional investors look out for, and will help you become a better investor.

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