Risk Grades, Price Monitoring Extensions and Capitulation


Q. Risk grade - what risk grade?


Have you noticed that for the first time in a long time that the Risk Grade on Rank has today dropped below 300. Risk grade - what risk grade?
Share

A: Broadly speaking the Risk Grade is a measure of share price volatility and used to compare the volatility of different shares or the overall volatility of a portfolio. RiskGrades are indicators of risk based on the volatility of returns. The higher the volatility of returns, the higher the RiskGrade of an asset. All shares have a Risk Grade. The higher the risk grade the more speculative the investment. That is why utilities often have extremely low Risk Grades of 100 or less. Shares for example that are in the utility sector often have a Risk Grade of around 100 as they pose very little risk of going tits-up. The higher the Risk of tits-up happening the higher the Risk Grade.

I remember shares such as Invensys, if I remember the spelling correctly, reached the dizzy heights of 800 or 900. Some shares go well over a 1,000. The lower the Risk Grade the safer the investment is. Cash has a Risk Grade of 0 (zero).

RiskGrades


The graph above shows some typical levels for Risk Grades for different asset classes.


Q. What is a 'Price Monitoring Extension'?


Have you noticed that for the first time in a long time that the Risk Grade on Rank has today dropped below 300. Risk grade - what risk grade?

A: This is usually connected with the Level 2 order book at the end of a trading day. A 'Price Monitoring Extension' is purely automated by the London Stock Exchange. A computerised 'flag' that activates the moment it recognises a movement in price that meanders outside a preset price boundary. It has no human intervention whatsoever and has no obvious logical relationship to price movement. Almost meaningless in investment terms. If, having drifted ever closer to the arms of morpheus while reading this explanation, ring the London Stock Exchange to describe it in greater detail and completely remove your will to live ! ;o)

Q. What is Capitulation?

Capitulation Day?

A: If you have not experienced it personally, I don't think you can ever know what it is.

But basically, it's a kind of sick feeling that you have lost money, and are no longer willing to risk losing any more, so you sell. It's the ancient 'limbic' system of the brain over-riding the rational part. It's why old farts say that you should only invest money you are prepared to lose.

Capitulation occurs when the market has fallen for so long that investors (having lost a large amount) become shell-shocked and believe that shares will never again rise; they thus sell out in a final act of desperation.

In more detail -> Capitulation is the state reached when many previously bullish investors give up hope that they'll make any profit soon from an asset or asset class, and just sell at any price just to get out. It's the final sell-down in a bear market when the last bull sells. Capitulation is a psychological state of pain and giving up hope which is a necessary part of any stock market cycle, and generally it occurs later than many expect. Just as UK residential property has appeared to many to be a no-brainer to many bulls in recent years as it's apparently completely obvious that there's easy money to be made, capitulation is the mirror image in which investors think it's completely obvious that profits won't be made in the near future from owning an asset. As then a beginner investor I remember clearly having a little bit of cash to invest in ~1991, walking in the rain down a street near Blackfriars and thinking there was no point buying any share with it, so I ended up buying some fixed-return National Insurance product from a Post Office: that's capitulation. I understand one recent example of capitulation was the apparent reaction of some institutions to Imprint's fall [i.e. get this useless company out of my portfolio at any price sort of mentality], but yet surprisingly capitulation doesn't seem to have happened to Northern Rock shares [for almost any other company the falls there would have prompted people to give up hope, but for NRK a few hedge funds have appeared trying to politically blackmail the UK government so hope still remains].

A true capitulation is usually a good medium-term buy signal, but IMO we're not yet near that stage for the UK consumer sector as a whole. IMO there's plenty more pain to come for the likes of banks, retail, and UK residential property. IMO the pain has hardly started, after all UK residential property prices, which are well over-valued, have hardly started to fall and so have a long way to fall and that fall (yet to come) is the problem that will cause UK consumer spending to fall much lower than it has so far.

How to recognize one? Well, the classic "capitulation" (the ideal typical event) is a two day phenomenon that comes at the end of a very long deep downtrend. Day one: a down day with a huge price range and a close well off the low of the day accompanied by big volume (sometimes also called a Key Reversal Day). Day two: an up day that takes out a large chunk of the previous days fall. The move up should keep on going in subsequent trading days.

A quick trawl though the all time lows in bear markets in FTSE 100 stocks shows me that this concept is not particularly helpful in the UK market, although I can produce some good examples from the bottom of the bear market in 2002/03:

3i on 10/10/02
Resolution on 29/01/03
ICI on 25/03/03
HBOS on 29/01/03
CNA on 11/03/01
CW on 09/12/02


 ...Continues here - Spread Betting - Selecting Shares to Perform...


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