Tuesday, August 17, 2010

Measuring Risk Appetite (1)

There are several ways for the technical analyst to measure the appetite for risk. We need to do this because when investors become fearful they begin to avoid risky assets which could snowball into a nasty correction. In the early stage of risk aversion investors initially stop buying risky assets. As the risk aversion spreads investors adopt a sheep like tendency and begin to sell risky assets. The final stage is typically a bearish stampede away from anything deemed to be risky.

I often measure risk appetite by a study of the Small Cap Index (XCS) vs. a Large Cap Index (XIU). In Canada our small cap index is for the most part commodity sensitive and so if we have a Risk Trade “ON” condition you would get over-weight into the commodity space or at least own the TSX Materials Index.

Our small cap / large cap spread (see chart) clearly displays an aversion to risk in late 2008 as investors bailed out of the Small Cap index crating a Risk Trade ”OFF” condition. As the panic of late 2008 and early 2009 subsided the selling in the small caps abated. In mid 2009 investors returned to the small caps and set up a Risk Trade “ON” condition – In May 2010 some degree of risk aversion returned and in mid July 2010 we returned back to a Risk Trade “ON” condition. Next posting I will use a different methodology to measure risk aversion in the U.S. markets


scseverin said...

Hi Bill. Thanks for the mid-term election market analysis. You're likely right about the recent low.

I recognize this kind of divergence exists between the XCS/XIU, however, I think we're all better off using the US markets to measure small cap / large cap divergence due to the relative illiquidity of some of the iShares Canadian ETFs. Does the Russell 2000 / DOW relationship show the same level of divergence?

Gettingtechnical.com said...


The XCS/XIU is a risk on/off tool related to commodity sensitive issues - the Russell/Dow is a measure of fear related to the outlook for the US domestic ecconomy - now over the last two weeks the Russell has been oversold creating an error of pessimism condition much like early 2009 - Bill C

Shawn Severin said...

Hi Bill. Knowing that you're a technology bull, I thought I'd send you this comparison of the 1920s DOW chart and the NASDAQ overlay. Some striking similarities. Let me know what you think.