What do the Risk Metrics say?

JC Parets
May 21, 2021

The market has been messy for a while and we've been reiterating that point for some time now. There are no new signals in terms of a direction, but we thought this is a good time to look at our risk metrics.

When we go through the metrics, we are essentially trying to put them in three buckets. Positive, Negative, and Neutral. Going by the weight of the evidence, we decide which way to go. Leave it all to the charts, they're your map for this treasure hunt.

There are several different metrics that we track on a global and a local level. The goal is to identify whether we are risk-on, risk-off, or waiting. This translates to how liquid one's portfolio could be at a given point.

Index view:

First up, let's take a look at what Nifty 50 is up to. We can see that since February this year, the market has been consolidating. This move has been limited between 15,470 and 14,250. What we also noticed early on was the divergence in the indicator. Momentum was losing steam despite price making new highs. That acts as an early signal of a possible change in momentum. Keep in mind, it is not the sole signal to track.

The levels that we're tracking now are pretty straightforward. We're looking for a breakout above 15,470 for a resumption in the ongoing trend. On the downside, we're keenly watching 14,250 to see if this level holds as the price movement continues to play out. So far, it's done a good job. Will that continue? We'll just have to wait and watch.

Click on chart to enlarge view.

Global Indicators:

The first metric that we will look at is the Emerging Markets ETF (EEM). This gives us a general direction of the emerging markets, of which India is a part. The long-term base breakout that we had observed in February this year seems to be giving away. The price is witnessing a minor correction. What we want to observe is whether this a short-term phenomenon or a failed breakout.

From a tactical perspective, this could just be a pause in the trend. But one thing is for sure, if the market is to resume higher, this chart must too. We are keeping a close watch on this one. If this does rollover, then we're in for a market correction.

Next up, we take a look at EEM relative to S&P 500. When the market recovered from the brutal correction in March 2020, we saw signs of a recovery in this ratio as well. Notice how the ratio bounced from the same level as that in 2003. Post that, emerging markets witnessed a monster rally! Since 2010 however, the sentiment has been negative, to say the least.

We saw a breakout of the downward sloping trendline in December 2020 as markets across the globe participated in the rally with gusto. But the ratio is now back below the downward sloping trendline and that does not bode too well for the economies in question.

If this ratio manages to display signs of recovery, we may see a robust rally in the weeks and months ahead. If not, the messy environment could continue to play out with a correction on the cards.

The EEM chart we looked at was a big base breakout. We tracked such breakouts in important economies as well. These breakouts and a continuation of those trends add strength to an existing rally. But what happens when the contrary unfolds?

Let's take a look at a couple of charts.

Here we have the Nikkei 225 which saw a 30-year base breakout earlier this year. Here's a zoomed-in version of the chart from a more tactical perspective. Why? Because we're looking for signs of change in sentiment or trends. They appear on shorter time frames before developing on longer time frames.

The Japanese index seems to have failed to resolve higher, which was the underlying trend. What we're seeing a correction after a consolidation. If this correction deepens, the long-term base breakout would result in a false breakout. This would then add to the negative view. But the fact that the trend didn't resolve higher is a short-term negative we need to track.

Similarly, The Euro Stoxx 50 is exhibiting possible signs of weakness. We're watching the level of 3900 closely to see if the breakout is able to hold its ground.

Next up, we look at a currency pair that is a great indicator of risk-on/risk-off sentiment. AUD/JPY. When this currency pair is moving higher, it indicates a market scenario where the bulls are willing to take on more risk. AUD is a commodity heavy currency and JPY is a safe haven currency. Thus when AUD moves higher, the expectation is that of growing commodity demand, higher inflation rates, expansionary economy, growth, etc.

What we're seeing here is that after a strong move from March 2020 lows, the price is halting at a long-term resistance. This overhead supply has been in place for three years. While we saw signs of a breakout of this level, the price quickly moved back below 85.

For the market to rally this chart needs to head higher. If not, we could see a consolidation or correction going forward.

India-specific indicators:

One of the most telling risk-on indicators has been the Nifty Small Cap 100 relative to Nifty 50. This ratio gives us an idea about the sentiment in the market. Comparing the riskiest stocks to the blue-chip stocks does bring out the true nature of a given rally.

Here the Small caps are continuing to display their outperformance against the large caps. What we'd like to see is a follow-through from current levels. If you notice, this particular level has a long price history. The ratio has taken support and found resistance here in the past.

The ratio continuing to move higher is positive for the market.

Now let's take a look at our universe. Nifty 500. For perspective, let's compare it to Gold. In a risk-on environment, the demand for a precious metal like Gold suffers in comparison to Equities, because market participants are willing to take on more risk and invest in small-caps and mid-caps. When that happens we tend to see underperformance in Gold.

With this ratio turning lower, we're seeing Gold outperform Nifty 500. This happens as market participants try to make a decision with regards to the direction of the breakout post the sideways move in the market. This indicates a slightly risk-off environment.

Here is the Copper/ Gold ratio that we like to track. This, however, is in INR.

Why do we compare Copper and Gold? Well, demand in Copper is a signal of growth and expansion. It alludes to an economy that's focussing on development. Gold on the other hand is generally considered a safe haven. That is not to say that Gold does not rally when Equities do, but the extent of the rally differs.

The Copper/Gold ratio has been halting at this level for the past eight years! If we were to see a commodity supercycle, as we've been talking about, the ratio will have to move out of this big base. For now, we're seeing a halt in the strong move in Copper as well, so this is another chart to track.

So what does all this mean?

Going by what we've seen so far, a majority of the charts are pointing at a messy market environment. What we can say though is that the risk-on sentiment in the market has faded slightly and it is important to remain agile with the current positions before the market picks its direction.

Make sure your risk management systems are in place. It is always a good practice to be alert. After all, complacency is when disaster strikes!

Thanks for reading and please let us know if you have any questions.

Allstarcharts Team

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