Sunday, June 5, 2011

Risk control

I have found that one of the secrets to getting ahead in financial markets is effectively controlling risk. But to control risk one has to be able to recognize risk. I have been seeing increased risk in the stock markets for some time now. And it seems that the rest of the market is becoming more aware of the increased risk as well.
One of the ways that I attempt to gain insight into the stock markets is by watching the movements in other markets. The bond market is a good "tell" for what the economy, and thus the stock market may do.

Over the last several months the price of oil has gone to $100 per barrel and above. The price of all food items has been rising in the stores, cattle prices have been in an uptrend, as have the prices of precious metals. There has generally been an inflationary trend going on.

Usually the long term bond markets abhor inflation. High rates of inflation cause bond investors to demand high rates of return on their bonds. After all, why would anyone loan out money for a long time at less than the cost of inflation. And long dated bonds are the most sensitive to inflation because they are for such a long time. A lot can change in a long time. Of course, the price of a bond is also related to the ability of the borrower to repay the loan. The better the credit of the borrower, the lower the interest rate or yield of the bond, and the higher the price of that bond, all other things being equal.

That brings us back to seeing risk in the stock market. If the bond market participants see inflation in the future, they will not bid up the price of the long term bonds. But, the long term US Treasury bonds have been in an uptrend for some time. (About 30 years, actually.) But it is the recent trend that I am considering. The recent action in the long bond is more predictive of DEFLATION that inflation. Deflation is what started in 2008. Deflation means lower prices for things. Sometimes lower prices are caused by too much supply, such as when a factory in China produces too many widgets for little cost. Or deflation can be caused by lack of demand. I believe that the deflationary forces that are returning are caused by lack of demand. Many people are still in debt. The job market remains poor. The federal reserve is set to stop the money presses, at least for awhile. And the political mood of the country is toward one of reducing government spending. Government spending and government debt has been on the rise for at 30 years and has been a continual "stimulus" to the U.S. economy. That deficit spending will have to decline or reverse sometime. I think this is what the bond market is predicting. And a slowdown in the economy is bad for stocks in general.

The problem with making a prediction in any market is the issue of timing. If I take money out of a market due to a perception of higher risk, what do I tell my self if I am wrong, and that market goes higher? I'll tell you what I tell myself. "I was wrong". And to avoid being wrong a second time, I get back into that market. But, if I always take the action that has the highest PROBABILITY of my desired outcome, over time I will ALWAYS come out ahead. So if I get out, and then get back in, I consider it to be the cost of insurance against losing money.
And to me, this stock market looks weak. I am out.

I am reminded of a quote from one of my favorite books, "Reminiscences of a Stock Operator", by Lefevre.

"If I am walking along a train track and I see a train coming toward me at sixty miles an hour, do I keep on walking on the ties? Friend, I sidestep. And I do not even pat myself of the back for being so wise and prudent".

I will get back on this train when it is going in the direction that I wish to travel. Here are some updated charts. I think that the evidence is becoming clearer and that more stock market participants are starting to see the evidence.

 Recent action the the long bond:

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