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As we have been forecasting for weeks if not months, in recent days we saw major stock indices decline back to levels not seen since 1997. Unfortunately, in spite of some positive comments from President Obama and from Federal Reserve Chairman Ben Bernanke, there remains a high risk that the stock market might continue its slide.

At this point, major indices have declined about 50% from their highs in 2007 and no market sectors have escaped without damage. Most investors have experienced significant losses and many are quite discouraged about the prospects for future market gains. While the economy currently remains weak and market risk is high, there will be opportunities for investors to make profits and they might not be long in coming.

Below is a chart showing exchange-traded funds (ETFs) reflecting three distinct sectors of the economy and markets. While all of these sectors continue to demonstrate high volatility and risk, each has also shown some signs of life. Gold (black line) has been rising since just before the start of 2009 and recently surpassed its former high. Gold has pulled back since then, but could resume its climb anytime.

The U.S. dollar has also been rising, thanks primarily to weakness in other world currencies. Although the United States faces unprecedented economic problems, many other nations are confronted by even more dire circumstances. As the world’s largest economy, the U.S. might be in the best position to be able to survive this global financial crisis. As a result, the dollar is receiving support from money flowing into the U.S. financial markets. In essence, there are many global investors who are betting on the U.S. economy.

The blue line on the chart is the Nasdaq 100–some of the strongest and largest technology companies in the world. Since bottoming in November 2008, this index shows a slight upward bias. When everything else is falling, just staying even is an evidence of strength. The technology sector has often led other sectors during bull markets. When this bear market finally relents, it would not be surprising to see the technology sector among the leaders.

We are watching a range of technical and fundamental indicators to help us identify when the time is right to start moving money back into the markets. One way we can measure market risk is by volatility. One commonly used volatility measure is the Chicago Board Options Exchange Volatility Index (VIX). In technical terms, VIX is a measure of the implied volatility of S&P 500 index options. A high value corresponds to a more volatile market and therefore more costly options. Options are often used to defray risk from volatility. If investors see high risks of a change in prices, they require a greater premium to insure against such a change by selling options. Sometimes called the fear index, it is a measure of the market’s expectation of volatility over the next 30-day period.

The chart below shows VIX compared to the price movement of the S&P 500 over the past few years. Notice how the expected volatility rose dramatically in the last quarter of 2008. While it has been lower since the beginning of 2009, it remains very high compared to prior years. So while some market sectors might be showing slight gains, the VIX is showing that on the broader market, risk remains very high. One indication of when to start moving back into the market is when VIX drops back into ranges we saw in early 2008 or before.

Other indicators we can watch to know when market health is improving includes things like advancing issues versus declining issues, new highs and new lows, P/E ratios and more. We also keep an eye on fundamental factors like unemployment rates, housing starts, consumer confidence, money supply, etc. Right now all of these indicators show that this is a risky time to jump into the market, even though a handful of sectors might be showing recent gains.

There are currently hundreds of billions of dollars sitting idle in money market funds, and in checking and savings accounts. When investors and traders believe the worst of the economic crisis is over, they will start reinvesting in stocks and mutual funds. The process can occur in just days because all it takes to reinvest the money is a phone call or an Internet order. By comparison, the economic stimulus package approved by Congress will move into the economy at a snail’s pace.

Once investors believe the stock market again offers a reasonable opportunity for reward versus risk, it would not be surprising to see some sectors advance dramatically in a fairly short time. When that occurs, our indicators should reflect the underlying changes in the market and allow us to re-enter at a less risky period.
F.S.

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