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.



DG's Trading Forum said...

I like that you are not looking at this oscillator in the simple view of "overbought" and "oversold", but are trying to incorporate trending tendencies when the normal read of the oscillator would say "overbought". "Overbought" can definitely become "more overbought". Interesting that it didn't work in reverse, though, because it does seem that "oversold" can also become "more oversold". Of course, that result would depend on what timeframe when into your sample, because we haven't really seen an environment with a slow, grinding decline where oversold signals have failed.

ryan said...

Coincidentally, one of your previous posts regarding asset class correlations sparked a similar thought for me; that of creating an index of risk assets and measuring it's performance against the broader market.

Using StockFinder 4, I created an index of the ratio between the 5-day ROC of price and the respective 10-day ATR of the following tickers: USO (oil), EEM (emerging mkts.), IWM (small caps), IJR (more small caps), XLK (tech), JNK (high yield corporates), UDN (dollar bear), and JJC (copper).

As you can see, the results are quite similar:

It is rather difficult to back-test using this index, however. Some of the symbols have a limited history and the inverse dollar relationship has not always been as it is today. Even so, this oscillator appears to present a valuable insight into relevant inter-market sentiment. Thanks for getting my gears turning, Dr.!