Saturday, February 27, 2010

The Risk Oscillator: An Intermarket Gauge of Sentiment

Here I've created an oscillator from the Risk Asset Index presented in the previous post. This measure captures whether risk assets are overbought (significantly above zero) or oversold (significantly below zero) over a two-week horizon. (See the above linked post for the specific assets that comprise the measure)

We can think of this as a kind of short-term sentiment gauge: when risk assets are overbought, confidence in global economic growth is strong. When risk assets are oversold, fears about global recession are relatively strong.

You can see from the chart above that this, like most sentiment gauges, serves as a contrary measure: it's when traders are most fearful of risk assets that we are most likely to see bullish moves emerge and vice versa.

Interestingly, my initial studies suggest that expectations for the S&P 500 Index (SPY) over the following five days tend to be positive when the Risk Oscillator is above 15 or below -15. Above 15, we see some positive momentum effects: bullish sentiment carries over to the next few days before expectations turn negative. Below 15, we see mean reversion and short covering over the following five days.

With some tweaking, this may make a worthwhile timing indicator.