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Risk-On or Risk-Off

Risk-on and Risk-off is an investment concept that refers to the actions taken by investors as the result of changes in investors’ risk tolerance levels. In risk-on situations, investors will take a higher degree of risks by bidding up prices higher. In risk-off scenarios, investors are more risk-averse and will sell, sending prices lower.

Investors’ appetites for risk tend to rise and fall over time. Individual investors are more willing to take on more market risks by buying higher-risk assets when confident about the economy and optimistic about their financial situation than when they lack confidence. Changing market sentiments occur with fluctuations in corporate earnings, economic data, central bank monetary policies and statements, speculative behavior, and other fundamental and technical factors.

Not all assets and securities carry the same degree of risk. Investors will often switch between different asset classes depending on their perceived risk in the marketplace. Within asset classes, stocks are generally considered the riskiest class of assets. Stocks are at higher risk than bonds, and in turn, bonds are at higher risk than cash. A market environment where stocks are outperforming bonds is a reflection of a risk-on market. On the other hand, when bonds or gold outperform stocks, the environment is a risk-off market.

Even within the same asset class and sectors, there are various degrees of risk. For instance, in the fixed income market, US Treasury bonds (BND) and Investment Grade corporates (LQD) are perceived to be safer than High Yield Junk bonds (JNK and HYG). In stocks, high beta (SPHB) or momentum (MTUM) are riskier than low-volatility (SPLV) or quality (QUAL). Within commodities, Gold (GLD) is considered a defensive and risk-off commodity that relatively outperforms its peers during market uncertainties. Cooper (JJC), on the other hand, is a risk-on commodity that performs well during periods of economic stability and growth.

Although S&P 500 sectors are considered liquid and safe investments, they also are subject to differing risk-on/risk-off classifications. For example, classic risk-on sectors include Technology (XLK), Communications (XLC), and Consumer Discretionary (XLY). Defensive and risk-off sectors are Utilities (XLU), Healthcare (XLV), and Consumer Staples (XLP).

Within different market capitalization levels, investors tend to favor different classifications based on their perceived level of risk-taking. For example, Large-caps (SPX) are more stable, liquid, and of higher quality than small-caps (SML), mid-caps (MDY), and micro-caps (IWC).

International stocks offer a varying degree of market and currency risks. Emerging equity markets (EEM) tend to be more volatile and riskier than developed equity markets (EFA).

Cryptocurrencies such as Bitcoin (BTCUSD) and Ethereum (ETHUSD) have become popular crypto investments, increasing risk exposure for individual investors. Bitcoin may compete with the US dollar (USD) as a counter-cyclical protective currency hedge. However, retail investors appear to be buying cryptocurrencies as a risk-on and high-growth investment rather than as a hedge against a weaker US dollar.

Ahead of the Fed policy meeting, this Wednesday one would expect investors to be nervous and cautious. You would not know from the recent Relative Rotation Graph (RRG) for the eight weeks ending November 1, 2021. The RRG study shows a decisive tilt in favor of risk-on assets. Most of the risk-on assets (i.e., Bitcoin, Consumer Discretionary, momentum, high beta, etc.) are firmly situated in the Leading and Improving Quadrants. On the opposite side of the risk spectrum, most of the risk-off assets (i.e., Low volatility, Consumer Staples, Utilities, investment-grade corporates, etc.) continue to struggle within the Weakening and Lagging Quadrants.

If the market is indeed transitioning into the melt-up phase, then the above relative rotations further support the basis for continued risk-taking, at least into the end of the year and early-2022.

Source: Charts courtesy of

Source: Charts courtesy of

Source: Charts courtesy of

Source: Charts courtesy of

Source: Charts courtesy of

Source: Charts courtesy of

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