The Weekly Orb: Investors are Chasing Risk

Over the last 18 months as the market has steadily risen without a significant correction,

investors have become more and more comfortable chasing risk. Risk chasing activities

have become so pronounced that investor sentiment has reached levels that are normally

associated with corrections.

I don't see any sign that a recession is imminent, but with risk seeking at an extreme, the

FED in tapering mode, and the market about to enter the seasonally unfavorable period a

long overdue correction is likely at hand.

We know that investors are seeking risk because the ratio of cash in money funds to the

stock market is at an all-time low. One of the aspects of the FED lowering interest rates to

help the economy is that it encourages (maybe forces is a better word) investors to search

for return, which is what I call chasing risk.

The absolute level of cash (not the ratio level) in money funds is below the level in 2006,

substantially below the level of 2009, and not much above the level in 2003.

While some of the money that has left money funds has gone into the stock market, a lot of

those funds has moved into the risker areas of the bond market.

Leveraged loan issuance has been extraordinary. When investors are pouring money into

leverage loans they are chasing yield (risk) and peaks in leveraged loan issuance have

corresponded to peaks in the stock market before corrections.

Not only has the volume of leverage loans soared, but the quality of those loans has

decreased. Over the last several years investors have been indifferent to the covenant

quality of the loans they are purchasing.

I attribute a lot of this to mutual fund companies pushing floating rate mutual funds as a

way to add extra yield "safely". It is not a way to add additional yield safely.

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We also see the willingness to take on risk in the IPO market. The last time so many money

losing IPOs as a percentage of all IPOs were issued was in Feb 2000.

When investors trade down to speculative OTC stocks (non-exchange stocks - Over the

Counter) to do trading they are chasing risk. High levels of OTC volume relative to NASDAQ

volume is a clear sign of risk chasing.

Margin balances also show an extreme willingness to take on risk. Margin debit balances

have never been higher.

Not only have margin debit balances never been higher, but the rate at which investors

have taken on margin debits is at a rate not seen since the early 1970's.

Buying climaxes are often a sign of purchase exhaustion in the market. A buying climax

happens when a stock reaches a 52 week high during the week and then the Friday close is

below the close from the prior Friday. So, during the week the stock hit a 52 week high,

but closed down for the week. The 3 month median number of buying climaxes is the

highest in the last decade.

There are a great number of composite sentiment indexes, but my favorite one is from

Tobias Levkocih of Citi Group. Unlike other sentiment models he has correlated his with

future 12 month returns for the S&P 500.

The model used put call premiums, put call ratios, short interest, cash in retail money

funds, margin debit levels, the AAII Bullish Percentage, Investors Intelligence Bullish

Percentage, retail gasoline prices, trade volumes, and commodity prices to establish the

current level of panic or euphoria.

In the chart below the thin blue line (scale on the left) is the level of Panic Euphoria

Model. The solid blue gray histogram (scale on the right) is the 12 month forward return of

the S&P 500.

The current level of his Panic Euphoria model has been associated with significant negative

12 month forward returns.

A year ago I had thought that the market was overbought and over loved and we were due for a

10% correction, but the FED purchases and "nothing else to do" pushed prices of risk assets ever

higher.

Right now it looks like the chase for risk is about to hit a temporary pause.

With the last employment report the number of private sector jobs is finally higher than it was at

the prior peak.

Total employment is still below the prior peak because government employment (all levels) is

still, significantly below prior levels.