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BusinessWeek asked market pros to identify the risk measures they consider most important for the stock and bond markets
It's still hard for a lot of investors not to be skeptical about the ongoing stock market rally, now entering its ninth month. But there's one thing for certain: Market volatility has decreased even as stocks have advanced. The VIX equity volatility index, a favored "fear gauge" for the stock market, settled at 22.84 on Nov. 10, down from 30.0 just a week earlier and over 80 at the height of the market panic in November 2008. But lower volatility shouldn't be confused with a lack of market direction, says Joe Cusick, an analyst at optionsXpress in Chicago. "A low VIX doesn't mean we won't have the market going up or down. It just means we won't have violent swings." While the most obvious risk indicators—volatility for equities and yield spreads over risk-free Treasury securities for bonds—show that market risk is down considerably since March, they only tell part of the story. There are lesser-known indicators that can also be used to gauge ongoing risk, according to Perry Piazza, co-chief investment officer at Contango Capital Advisors in San Francisco. Comparing Different Markets
One such indicator is the ratio of small-cap stock performance to large-cap performance, as measured by the Russell 2000 index against the Standard & Poor's 500-stock index, for example. Since big gains by small caps show a strong appetite for risk, a downward turn in the ratio could indicate that risk appetite is changing, he says. When the government starts to rein in the money supply, he says he would expect to see price appreciation in small-caps slow. In preparation,Contango is tweaking its portfolios, shifting to an allocation that emphasizes large-caps instead of a broader mix of small-, mid-, and large-caps. Piazza is also watching the ratio of emerging market stock performance to that of developed markets, as measured by the MSCI Emerging Markets index compared with the MSCI All-World index or the S&P 500. This is another way to gauge investors' taste for risk — on a broader international scale. Government-Linked Liquidity
StatPro, a London-based provider of data and analytics for the investment management industry, uses hundreds of thousands of individual risk factors as inputs for the risk analyses it runs for client firms. One factor that's relatively accessible for individual investors is the price of interest-rate swaps for various currencies. For example, the U.S. 10-year interest-rate swap has been trapped in a fairly tight trading range over the past two months. On the lower end of the range, the rate has been kept down by a lot of government-linked liquidity amid lingering fears about a double-dip recession, while worries about inflation fears have supported rates on the upper end, according to Dario Cintioli, head of risk management products and services and complex pricing at StatPro. The 10-year Treasury rate sank to a low of 2.86% in early March when the economic outlook was bleakest and peaked at 4.20% in early August amid a spate of optimism about the economy, but has been trading between 3.30% and 3.80% since September, says Cintioli. "To bring rates down [substantially] you would need bad news on the economy," while a breakout on the upside would signal a rising inflation risk, says Cintioli. Change in Fed Tune?
For Tom Sowanick, chief investment officer at Clearbrook LLC Financial in Princeton, N.J., the big concern is less hard numbers than subtle language changes in policy statements from the Federal Reserve's Open Market Committee. He expects to see the Fed send a warning of language changes to come at the end of the committee meeting in late January 2010. Sowanick points to one signal of current market expectations regarding the Fed: Year to date, as of Oct. 30, returns were -2.48% across all U.S. Treasury bonds. The only other years when there were negative returns on Treasury debt were 1994 and 1999, when the Fed was raising interest rates. That doesn't bode well for returns once the Fed feels compelled to start hiking rates again next year as inflationary signs re-emerge, he says. The 10-year break-even inflation rate, a measure of investors' inflation expectations, has gone from -0.2% a year ago to 2.25% on Nov. 9. That's perilously close to the 10-year average rate of 2.5%, which suggests the Fed will have no choice but to start raising rates before very long, Sowanick says. Watching for Divergence
Given all the money — $267 billion — that's flowed into low-return mutual funds holding lots of one-to-three-year Treasuries so far this year, investors in these funds will be stuck in a bad investment once interest rates start to rise again, says Sowanick. These bonds are perpetual duration securities that get rolled over rather than maturing. Yet most investors believe they'll be able to get out whole when the bonds "mature," he says. Perpetual duration securities serve investors well as long as interest rates keep declining. But if you think rates will rise anytime soon, you're better off selling your holdings and reinvesting in shorter-term bonds at higher rates, says Piazza at Contango. As for equities, Cusick at optionsXpress is on the lookout for "anything that gives you a heads-up on a divergence in trends" on stocks' technical charts. Eyeing Relative Strength
For example, even though the SPX, the cash-settled index that tracks the S&P 500 index, has been up over the past six trading days, last week it dipped below its 50-day moving average. That could potentially mean that more negative sentiment is coming into the market, he says. Cusick is also keeping an eye on the Relative Strength Index (RSI), which measures the magnitude of market gains over a given time period against the magnitude of losses over that period, and the New York Stock Exchange Advance/Decline Line, which, by showing how many stocks are advancing vs. declining, tells you the number of buyers vs. sellers in the market. Oversold Condition Could be Close
Typically, an RSI over 75 suggests stocks are overbought, while a reading under 30 shows stocks are oversold. The Advance/Decline Line reading of -1,000 or lower suggests an oversold condition could be approaching, he says. The reading was around -765 on Nov. 10. Options traders check these signals to give them more confidence about where options prices are headed over the next one to three months "so you don't feel like you're chasing market weakness or strength," says Cusick. But these technical signals are best used in combination with each other instead of independently, to avoid getting incomplete data or false signals. Keep Monitoring Risk
There's a lot of talk that as we head into the final lap of 2009 investment managers who have missed the rally can't afford to stay on the sidelines for fear of showing weak returns for the year. But for those who aren't convinced, it's a good idea to keep monitoring the risk signs in case a sudden turn in the markets awaits.