Monday, September 21, 2009

Measuring the Risk Appetite of Stock Market Investors

There are many ways of assessing whether U.S. equity traders and investors are behaving in risk-seeking vs. risk avoiding ways. One is to evaluate the relative performance of growth oriented sectors vs. more defensive ones (such as XLY:XLP). Another is to look at the relative performance of smaller, growth-oriented issues (such as IWM) vs. established large cap blue chips (SPY). If investors are bullish toward risk, they will tend to buy the most aggressive, growth-oriented names; if they are bearish about the economy, they will gravitate toward the safest, most defensive blue chips.

Another way to assess the risk appetite of equity investors is to examine the relative performance of the unweighted S&P 500 Index (RSP) vs. its capitalization-weighted standard (SPY). If traders are bullish on the economy and risk seeking, they will tend to prefer the smallest components of the S&P 500 Index, and RSP should outperform SPY. Conversely, if traders are bearish on the economy and risk averse, they will tend to stick to the safest of the blue chips and SPY should outperform RSP.

We can see from the chart above that the relative performance of RSP:SPY topped in 2007, ahead of the broad stock market. It also bottomed in late 2008, ahead of the March, 2009 stock market bottom. Notice that the relative performance of RSP:SPY has been hitting new highs in recent trading, suggesting that bullish risk appetite is alive and well in the stock market. I would not expect significant market declines as long as that is the case.