Risk-on, risk-off (RoRo) investing describes a process where investors move to riskier potentially higher yielding investments and then back again to supposedly lower yielding investments which are perceived to have lower risk.
In this article, we will review some indicators which allow you to monitor current market's risk appetite.
Rising of risk appetite, which would tend to be good for stocks. To measure risk appetite, ratios can be invaluable tools for making investment decisions. In the following discussion, we rely heavily on ratio analysis:
The traditional macro instruments such as commodities and currencies are difficult to value. But by far the biggest macro market - the bond market - is largely priced off central bank perceptions of what the economy is doing, and risk assets tend to be priced off those bond markets. Since mispriced assets can become even more mispriced depending on the macro climate and central banks' reading of it, timing is everything. So, an understanding of the 'big picture' for you is far more important than valuation.
Finally, it is important to understand that volatility does not necessarily mean risk. Volatility typically increases when equity prices are falling, however volatility levels can rise for a variety of reasons. Uncertainty about the outcome of an event like hitting the debt ceiling could push volatility levels higher without sending equity prices sharply lower.
In this article, we will review some indicators which allow you to monitor current market's risk appetite.
Risk-on vs Risk-off
Rising of risk appetite, which would tend to be good for stocks. To measure risk appetite, ratios can be invaluable tools for making investment decisions. In the following discussion, we rely heavily on ratio analysis:
- SPHB:SPLV (High Beta/Low Volatility ratio)
- Risk on if high beta outperforms low volatility stocks
- Low Beta S&P includes the more defensive sectors of the market, including consumer staples (NYSEARCA:XLP), health care (NYSEARCA:XLV) and utilities (NYSEARCA:XLU). Representative names include Procter & Gamble (NYSE:PG), Becton Dickinson (NYSE:BDX) and Southern Company (NYSE:SO).
- High Beta S&P includes companies from the more cyclical and economically sensitive sectors, including industrials (NYSEARCA:XLI), consumer discretionary (NYSEARCA:XLY) and technology (NYSEARCA:XLK). Representative names include Yahoo (NASDAQ:YHOO), Delta Air Lines (NYSE:DAL), and Best Buy (NYSE:BBY).
- XLI:SPY
- Risk on if the ratio spread between a very cyclical and less or even non-cyclical asset rises
- XLB:XLU
- Same as above
- $COMPQ:$INDU
- Risk on if Nasdaq outperforms Dow
- SPY:IEF (Stocks/Bonds ratio)
- Risk on if stocks outperform bonds
- When the demand for stocks is greater than the demand for bonds, the aggregate economic outlook of all market participants is “net bullish.”
- Conversely, when the demand for conservative bonds is greater than the demand for growth-oriented stocks, the aggregate economic outlook of all market participants is “net bearish.”
- Also, historically, during risk-off periods, long duration Treasuries becomes inversely correlated to equities
- SLV:GLD
- Strength in silver relative to gold tends to occur during economic expansions and periods when the ‘risk on trade’ is in favor.
- However, whenever the RSI on the silver/gold ratio soars to 80 or higher it indicates excessive speculation.[7]
- XLY:XLP (Consumer Discretionary/Consumer Staple Ratio)
- How to interpret?
- High ratio — risk-on
- XLY (consumer discretionary section) is the most economically sensitive sector.
- XLF and XLK (Financials and Technology)
- How to interpret?
- Both are risk-on assets
- Rarely will they head in opposite directions. If they do, use XLY and XLI for as tie breaker
- XLI (Industry) is economically sensitive sector because it supplies companies with capital-intensive goods and services needed for their operations.
- JNK:TLT
- Risk on if junk bonds outperform treasuries
- $TRAN:$UTIL
- $DRG:$SOX (PPharmaceutical/Semis Ratio)
- How to interpret?
- High ratio — risk-off
- Defensive rotation: As healthcare gains on semiconductors. It signals a change in sentiment and outlook (i.e., become risk aversion)
- VONG:VONV
- Risk-on if the Russell 1000 Growth Index has easily outperformed the value sector.
- Relative Performance of SPY, TLT, UUP, GLD, USO
- How to interpret?
- Risk-on if you see
- Strength in SPY and USO
- Weakness in TLT, UUP, GLD
- Stocks and commodities are riskier assets
- Dropping of US dollar (UUP) may be foreshadowing a return of risk appetite
- EEM
- If you are bullish on risk long-term, you should hope emerging market (EEM) stocks begin to reassert some leadership.
- FXA (Australian Dollar)
- Continued strength in the Australian dollar would be an encouraging sign for future economic growth and risk assets in general
- Rising of risk appetite would tend to be good for commodities and commodity-dependent currencies.
- VEU
- Vanguard All-World Index Ex-U.S. ETF (VEU) is a good vehicle to monitor global risk tolerance and recession risks
- Insider Buying
- More buying means less risk
Conclusions
The traditional macro instruments such as commodities and currencies are difficult to value. But by far the biggest macro market - the bond market - is largely priced off central bank perceptions of what the economy is doing, and risk assets tend to be priced off those bond markets. Since mispriced assets can become even more mispriced depending on the macro climate and central banks' reading of it, timing is everything. So, an understanding of the 'big picture' for you is far more important than valuation.
Finally, it is important to understand that volatility does not necessarily mean risk. Volatility typically increases when equity prices are falling, however volatility levels can rise for a variety of reasons. Uncertainty about the outcome of an event like hitting the debt ceiling could push volatility levels higher without sending equity prices sharply lower.
References
- The Fat Patch Weekly Summary
- How low oil prices went from blessing to curse
- China's Year of Monkees
- China Volatility Raises the Question: Did the Fed Make a Mistake?
- What's behind slowdown? (Deutsche Bank)
- Is This A Bear Market?
- Bob Hoye Interview
- Risk “On/Off” indicator hitting 5-year support
- The decline has taken the ratio to 5-year rising support. The pattern looks just like global markets, which are testing 5-year rising support
- If the ratio does at support, it will have a large impact on portfolios come summer
- 90-Day trend is down, 5-year trend is up
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