As most are aware by now I create a lot of weekly composite indexes to try and strip out the noise of a single indicator at any given time.   While there are many people that track bullish and bearish sentiment, new highs versus new lows, volatility, rate of change, etc. in order to monitor "risk" in the markets; I have combined all of these items into a weighted index to provide a more macro view of the "psychology" of the market.

As a contrarian investment manager I am looking for the periods in time where "risk" is outweighed by the potential for "reward."  More importantly, I am also looking to derive a more optimal entry point for holdings without getting caught in a proverbial value trap.   This is the sole purpose of the STA Risk Ratio indicator. 

I have taken the weekly results of the indicator and then smoothed them with an 8-week average to refine the indicator to more of an oscillator.  Currently, the indicator has reached extremely bearish levels only witnessed during the peak of the market cycle back in 2008.   Notice, that I said "peak".   I have notated on the chart the indicator levels after the initial selloff in the markets in 2008.   That initial sharp reflex bounce in 2008 drove the index above previous resistance levels without triggering a "buy signal" on our longer term indicators as we noted last week.   This is critical to note because it was the beginning of a much bigger correction in the market as opposed to the media which were touting it was time to "buy" just before one the biggest crashes since 1928.  While I am not saying that we are about to have a second financial crisis in the market; the markets and the economy are substantially weak and are prone to event driven selloffs.

While we have recommended modestly increasing exposure on a pullback and consolidation it is critical that you remain focused on the overall trend of the market which is still clearly negative.   In 2008 the reflex bounce quickly ended as the underlying fundamentals of the market and the economy deteriorated.  This time we have had a strong reflex bounce from very oversold conditions following 5 months of selling through the end of September.  Furthermore, October through April tends to be the seasonally strong time of the year for investors. 

However, there is a laundry list of things to be paying attention to:

1. Earnings have been okay but not stellar and forward guidance is a concern.   If you look below the headlines of the economic reports you are seeing weakness on the production side and the ability to pass along price increases may be at an end.   This could quickly lead to margin compression in the coming quarters.
2. Europe is not a done deal by any stretch of the imagination.   The market rallied strongly on the "deal" but no "deal" has actually been done.   Without support from China, which is highly unlikely, there is a high probability, between the banks balking at being the only ones to take a haircut and the lack of agreement between leaders, that the deal falls apart.
3. Italy and Spain are rapidly deteriorating as the risk spreads are rising indicating that they may be the next to fall.  The Euro bailout fund is woefully too small to handle that problem.
4. The economy is weak despite the bump in the GDP in the 3rd quarter.  Look for deterioration of the consumer in coming months and a potentially weak holiday shopping season.
5. Commodity prices have been rising during October which have absorbed all of the "tax cut" seen during the Q3 economic rebound.
6. The Fed is out of bullets and while they have talked about QE 3 there is a high probability that little help is actually on the way.
7. The "Super Committee" will fail at coming up with sufficient spending cuts within their given time line.   This will result in very strong spending cuts automatically put in that will throw the economy into an almost immediate recession.
8. There is more political infighting about to come over the "jobs bill" and the expiration of the extension of the "Bush Tax Cuts".  If the cuts are not extended again there will an additional drag on the consumer.
9. The dollar is weakening once again driving up import prices and impacting the consumer.
10. Bullish sentiment is back to elevated levels and previous oversold conditions have quickly evaporated. 

All of these issues, and there are more than just these, do not bode well for a resurgence of bullish sentiment and a revival of the cyclical bull market in the near term.  Without the heavy lifting assistance of the Fed through an expanded and immediate resumption of asset purchases there is really very little to propel the markets substantially higher from here.  However, the rebound in the economy and the sharp rally in the market took away what "reasoning" the Fed could have used to launch a third QE program.   Effectively, the Fed is now virtually handcuffed.

I will continue to monitor our risk indicator closely for the best opportunity to increase risk profiles in portfolios and update this post regularly.  However, at the current time the things that are potentially wrong with the economy and the market far outweigh the things that are potentially right.