Each time stocks go through a correction I like to check in with my Risk on - Risk off chart to see what it is telling me. The chart is just the ratio of the price of stocks (SP500) to the price of bonds (20 year treasury). It’s very basic in its premise but it tells a powerful story. Simply put, when the ratio is rising, you want to be invested in stocks, when it is falling you want to be in bonds. When it is going sideways, you need check in regularly to watch for a break out and make the necessary changes in your portfolio.
I have lengthened the time frame of the Risk on – Risk off chart below to include more than 12 years in order to show enough data to do a comparison of the current run from the bottom of a sell off (2009) to that of a past bottom from a sell off (2003). Let me to get you to look to the left side of the chart from 2003 to 2007 where the ratio climbed the upward sloping blue support line until the first quarter of 2007 where it peaked in May. The ratio fell back to the blue support line without crossing it and made another push higher in September but failed to make a new high and then quickly crossed below the blue support. Once below that, it quickly sliced through the red horizontal support and found a bottom in April 2008. Once again, it tried to rally, fell way short and could only make it back above the underside of the red horizontal support line (which has now become resistance). We all know what happened after that, the stock market went into free fall losing more than 50%. Before we move on to what is happening today, note how well this ratio chart identified a time to step aside from stocks. If you would have followed the rules of exiting stocks when the ratio fell below both the upward sloping and horizontal lines (I have that time indicated with a dashed blue vertical line), you can see you would have avoided most of the stock market decline (follow the dashed blue vertical line down to the bottom pane where it crosses the price of the SP500 --- you can see how good a job it did).
Now, if you shift your focus to the most recent move from the 2009 bottom, one of the first things that should jump out at you is the fact we appear to be in a topping pattern which is occurring at almost the same exact level as the 2007 top. Other things of note are 1) the rise is similar in slope 2) like the past move, the ratio has respected the blue upward sloping trend line 3) while it looks as if the ratio may be topping, it still sits above both the red horizontal and blue upward sloping support line allowing for an attempt at another push higher if it so desires (similar to what occurred in 2011).
The discipline of following a system (one that includes this indicator as one of many) I find extremely helpful to ensure the balance and objectivity one need to make good investment decisions. While it all may change tomorrow, this indicator is telling us stocks are still the place to be.