A key risk-on relative to risk-off ratio is not yet calling for a dash for the safe-haven exits. As we noted on August 21, the recent important higher highs made in gold (GLD) and silver (SLV) signal:
- Confidence that a turning point has been reached in the euro debt crisis.
- An expectation that more intervention is coming from the Fed.
One effective method to monitor the health of stock market rallies is to evaluate the ratio of “risk-on” to “risk-off”, or the performance of stocks (SPY) relative to intermediate-term Treasury bonds (IEF). When the ratio is rising, risk-on is in favor. When the ratio is falling, risk-off is carrying the day.
The chart below looks intimidating and busy, but if you review each portion in isolation the concepts are easy to follow.
Point A shows the S&P 500’s peak in April 2012. Point B shows a warning flag for risk that was in place in the form of a lower high in the stock/bond ratio. Point C shows no such warning for stocks is present today, as the ratio recently made a higher high as stocks made a higher high. However, point C also shows the stock/bond ratio is near two forms of possible resistance. Should a multiple-day correction come in stocks, point D shows three areas of possible support near 1,380 on the S&P 500. The “cluster” of trendlines near point E highlights possible support for the stock/bond ratio. Should support at point E not hold, point F identifies the recent stock/bond ratio breakout level, which has acted as support and resistance several times in 2012; it may again act as support.
How does all this help us? As long as the stock/bond ratio continues to make a series of higher highs and higher lows, a bullish trend for “risk-on” will remain intact. If the ratio makes a lower high or lower low, it would send up a red flag for stocks. As long as the S&P 500 remains above 1,380, we should view any corrective activity as a normal pullback within the context of an ongoing bullish trend for stocks.
Having experienced some nice gains in our oil positions purchased in early July, we cut back a little on OIH and added silver (SLV), which appears to have a better risk-reward ratio looking out several weeks. We still favor risk-on, but respect the possible resistance near point C in the chart above. Maximum flexibility and open-mindedness is important after stocks have staged an impressive rally. We are not adverse to booking profits, or rotating to assets with more favorable risk-reward profiles, similar to the SLV for OIH swap we made on Tuesday.