Investors are not afraid of risks! Or not yet?

Stock markets are currently experiencing another period of increased nervousness. This nervousness can be explained by the downturn in economic activity, the US central bank’s interest rate policy and fears of a Chinese real estate crash.

By analysing the relative performance of more risky investments versus defensive ones, we aim to give some context to the current stock market correction.

Is this a trend reversal? Should investors rush towards the exit? Or is this just a temporary lull in a structurally rising stock market trend? In our recent seasonality analysis, we asserted that it was the latter. Let’s take a closer look at the relative ratios between riskier investments on the one hand and more defensive asset classes in the US on the other. Until further notice, the United States will continue to play a dominant role for international stock markets. In the upper part of Graph 1, we see the relative performance of high yield bonds compared to US Treasuries.

High-yield bonds are naturally more risky than traditional treasury bonds. These types of bonds are generally issued by (smaller) companies that often do not have such a robust balance sheet. This is why it is also a good barometer for measuring investors’ risk appetite. Investors buy this type of bond if their appetite for risk is high.

As of April this year, we have seen these high yield bonds (represented by the HYG ticker tracker) outperform US Treasuries.

In other words, this is a clear indication that investors still prefer risk over adding defensive strategies to their portfolios. If we are indeed on the verge of a sharp decline, we would probably see a falling trend in this ratio – certainly not a rising one. For us, this is already a first signal that we should not rush to a stock market exit just yet!

In the lower part of Graph 1, we see the relative performance of the consumer discretionary sector (sector tracker ticker XLY) versus the consumer staples sector (sector tracker ticker XLP).

In the consumer discretionary sector, we find major US companies such as Amazon and Tesla. Traditionally, such companies do well if there is little doubt about the economic climate. Consumers spend a lot of money on products on the Amazon website or buy electric cars, for instance. In economic downturns, investors often opt for defensive stocks in the food and beverage sector because they are less dependent on the economic cycle. And here, too, the market signal is clear: since January of this year, consumer discretionary stocks have outperformed defensive food or beverage stocks.

Graph 1: relative performance of defensive vs. offensive asset classes (VSA)

Source: All Star Charts

Conclusion

Investors still have a healthy appetite for risk at the moment. Asset classes that are slightly more risky outperform traditionally more defensive asset classes. This is an important signal for us not to be overly pessimistic at this stage about the near future of the stock market. As long as we do not see a stronger relative performance of defensive investments, we will continue to adopt a constructive stance. In other words, we see the current stock market correction as an opportunity to strengthen equity positions!