RISK APPETITE

The Dow Jones Utilities Average comprises 15 utility stocks drawn from electric, gas pipelines, telephone companies, and so forth. A rise in utility stock prices indicates investors are anticipating falling interest rates. That's because utilities are big borrowers and their profits are enhanced by lower interest costs. Conversely, the utility average tends to decline when investors expect rising interest rates. Because of this interest-rate sensitivity, utilities tend to outperform in period of pessimism and deflationary expectations, and severely underperform during periods of overconfidence and bravado.

This study compares high beta and low volatility stocks. The SPHB ETF consists of 100 stocks within the SP 500 with the highest sensitivity to market movements over the last 12 months, and the the large-cap oriented SPLV, on the other hand, is devoted to 100 of the lowest volatility stocks. Constructed in a similar fashion, each constituent in the SPHB is given an equal share of assets. The first includes mainly discretionary, financials, and technology companies, and the second reflects a more conservative investing style with large allocations to utilities, financials, and consumer staples. During defensive days, when investors accumulate in low volatility areas, the SPLV would typically take over as the dominant percentage gainer. When risk taking resumes the SPHB usually leads the way.

The yen gives us some insight into risk appetite rising when investors do not want to deal with risk. The problem with using the USD/JPY cross is that it is subject to the overall strength and weakness in the dollar. Even if risk appetite stays the same, if the dollar is strengthening or weakening, USD/JPY will change. Instead we can look at the NZD as a high yielding currency serving as a proxy for high yielding instruments. New Zealand and Japan have a large central bank benchmark interest rate differential, making it a popular carry trade. Therefore, the NZD/JPY pair tends to decline when risk aversion permeates the markets, and rise when the market is turning risk unfriendly. NZD is also a so-called commdoll, that is, a commodity-related currency.

When money is chasing return and market mood is improving, capital tends to favor equities. As a general rule, the NASDAQ -flush with technology stocks- tends to imply retail money, while the S&P 500 tends to reflect institutional investment and the Dow Jones international big money. The allure of what is popular is hard to resist. That is why when you see the NASDAQ falling it is labeled as “risk-on”. Alternatively, once the fear of losing subsides the NASDAQ tends to outperform, as tech stocks may get irrationally sold. The market themes that are expected to affect investor's sentiment can be followed by clicking here here. 

Dow Jones Transportation Average is a U.S. stock market index of the transportation sector. The central idea behind the Transportation Average as leading the other Dow averages was that if underlying businesses are going to do well, the prospects for the Transportation providers had to be strong. There are now many service oriented companies included in the Industrials Average that may perhaps prosper without a similar rise in the Transportation companies, but the broad idea that the Transportation Average and the Industrial Average are interlinked will remain at the center of Dow Theory.

Copper is a barometer of economic health. It's the world's third most widely used metal, after iron and aluminum, and is primarily used in highly cyclical industries such as construction and industrial machinery manufacturing. Copper is then considered a coincident indicator for bond prices and utilities which tend to fall when copper rises. A rise in copper prices invites risk-on flows and shows that markets are turning to riskier assets. Falling copper prices, on the other hand, implies economic weakness forcing cash into safe havens.

Industrial metals like aluminum and copper are especially sensitive to economic trends because they have a myriad of industrial applications apart from being used in the building of autos and homes. For this reason, normal intermarket relationships dictate that industrial metals usually have a much closer correlation to bond prices than other commodities that are more weather-related or prone to supply shocks. Base metals rise on the back of rising risk appetite, and fall with expectations of weaker economic conditions.

Another way to gauge the extent of market risk-taking is looking at junk and corporate bonds. At times of economic uncertainty and higher probability of default, yields are pushed higher to compensate for the risk of default, and so the price of those bonds decreases (remember yield and price go opposite), suggesting rising risk aversion. The alternate scenario, when investors accumulate confidence in purchasing higher-yielding and therefore riskier- assets, the intensified risk appetite manifests in rising high-yield bond prices.

Emerging markets are synonymous to higher growth and higher yield. However, all high returns must be judged within a risk framework: this can be political risk, bankruptcy risk, less liquidity, and foreign exchange rate risks, among others to be considered when trading EM assets. Countries which offer high yields, such as Brazil, South Africa, and Turkey, are poised to benefit the most by any risk-on flows, but they are also more susceptible to global monetary tightening than are developed markets. As such, these markets display a strong positive correlation with risk.

FAANG is an acronym for the five most popular and best performing tech stocks in the market, namely Facebook, Apple, Amazon, Netflix, and Alphabet’s Google. The massive combined market capitalization of the FANG stocks is explains their dominance in several benchmark indices. Gains in these stocks are attributed to investor's continued appetite for risk. When people are buying growth stocks such as the FAANG group instead of value stocks which are associated with economic strengthening, the market is considered to be growing roses. Conversely, a burst in animal spirits is usually reflected in high-flying FANG technology stocks turning South.

The FNDA index measures the performance of the small company size segment by fundamental overall company scores, which are created using companies included in the Russell 3000. The SCHX, on the other hand, seeks to track as closely as possible, the total return of the large capitalization companies included in the Dow Jones U.S. Large-Cap Total Stock Market Index. Small caps, being more volatile, are easier to move, reason why they tend to outperform large caps in periods of rising confidence and drastically underperform during corrections.

Gyrations of the different sectors in the business cycle reflect distinct changes in the rate of growth in economic activity, as well as changes in the employment backdrop and monetary policy. When the stock market is in a process of discounting potential economic slowdown, for instance, staples tend to outperform as money chases recession-proof, dividend paying companies like tobacco and healthcare. Consumer discretionary stocks, in turn, depend on capital spending and consumer demand, and tend to outperform during periods of increased optimism.

First and foremost, risk aversion can lead to liquidation and/or profit taking. The process of unwinding these trades may result in a need to buy back funding currencies like the U.S. Dollar and Japanese Yen. When the above charts convey a sense of nervousness in the markets, risk-sensitive currencies will be keept in demand.

A few years ago, in 2015, the ECB announced its massive QE program changing the dynamics of Euro trading. The quick enlargement of the ECB's balance sheet and the negative deposit rate sent money away from the euro-zone to find higher-yielding, riskier assets elsewhere. The Euro turned into a funding currency, not dissimilar from the Japanese yen.

In a serious risk-off environment one should see major shifts also in the price of gold. Should gold do not appreciate, means that traders are not feeling the environment as dangerous.

Likewise, in times of risk aversion we would expect pairs like NZD/JPY and AUD/JPY to fall lower. When that is not the case and these JPY-pairs holds up well, it suggests that there is less fear than market indicators show.

Oil prices do not having much fun in a risk-off environment either which shouldn’t come as much of a surprise considering global growth fears and their impact on risk are intrinsically linked to future oil demand. The Canadian dollar, especially against the Japanese yen should be monitored in extreme risk environments, be it risk On or Off. More information about commodity related currencies, visit the Commodities topic page.

During a risk-off event, dumping equities for bonds is another natural response. To get a broader view on what macro themes impact each currency and related markets, please check the Macro Themes page.