This week’s indicator is called the Risk-On/Risk-Off Indicator, or RO/RO indicator for short. It’s designed to gauge the relative risk tolerance in the investments landscape. In other words, it is a gauge of economic confidence.

The Risk-On Index, shown in the second clip from the top, is comprised of components that have stable positive correlations with global stocks (the MSCI ACWI), which is shown in the top clip of the chart. By contrast, the Risk-Off Index, shown in the third clip, has components that are negatively correlated with global stocks, and thus tend to do well during periods of risk aversion. When combined, we get the Diffusion Index (bottom clip), which determines whether the overall macro environment is a headwind or tailwind for stock prices.

Right now, for example, roughly 67% of the components in the Risk-On Index are positive (above their 200-day moving average), whereas only about 17% of the Risk-Off components are positive. The difference between the two, then, is 50%, which is the overall reading for the indicator. As the performance box shows, readings above 50% for the RO/RO indicator have produced above-average annualized gains for global stocks, going back to 2007.

This is likely a big reason why stocks have done so well lately. Many of the Risk-On components like the Information Technology-to-ACWI ratio and high-yield bond prices are doing well, whereas the Risk-Off components like the Consumer Staples-to-ACWI ratio and Utilities-to-ACWI ratio are underperforming. In essence, investors are actively embracing risk, akin to the Marvel Comics character the Human Torch exclaiming “Flame On!”—except in this case, the market is shouting “Risk On!”

Historically, Risk-On periods have tended to last for several months, an encouraging sign that this economic confidence could persist for a while longer. Last year was dominated by Risk-Off components, so a sustained display of Risk-On strength from this point onward would strengthen the case that we’ve put that period of weakness behind us.

 

This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.

Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.

Past performance does not guarantee future results.