One of the things I’ve started paying close attention to recently is the trend in risk appetites. Are investors embracing or shunning risk in the markets? Answering this question can help to understand the strength of the underlying trend.
The chart below plots the S&P 500 Index (in blue) alongside a custom index I created to track sector preferences (in red). You will notice that an uptrend is stronger when investors are embracing riskier sectors, pushing the red line higher, and vice versa.
It’s interesting to note that as the stock market recently traded to a new, record high, investors haven’t embraced risk to the extent that it pushes this risk appetite index to a new high – not even close. A similar divergence was present at the 2007 top and at last summer’s new high in price.
Equity bulls should hope investors soon embrace risk taking again and to a significant degree. Otherwise, the rally over the past several months may prove unsustainable.