“Risk-on” and “risk-off” are popular trader jargon often heard in the airwaves nowadays. The former term refers to the rush into risky assets (e.g. stocks, commodities, etc.) when optimism is high, and the latter refers to the flight to safe havens (e.g., Treasury bonds, gold, etc.) when the market gets nervous.
In recent years, we’ve seen no shortage of such swings in the stock market. We’ve had the financial crisis of ’08, the Great Recession that officially ended by mid-2009 (though for many it hasn’t been much of a relief), two quantitative easings, the ebbs and flows of the European debt crisis, just to name a few. Already this year, we’ve seen a risk-on and a risk-off period.
Early in the year, optimism over US economic growth (inflated by an unusually mild winter) and relative lack of terrible news from Europe sent stocks to their best start in more than a decade. Then as the reality over the still sluggish US economy settled in, worries about slowdown in China mounted, and high bond yields and political turmoil in Europe started to cause jitters, stocks lost some of their momentum. From January through February, the S&P 500 was up 8.6 percent, but only 2.4 percent during the next two-month period (in price return).
Although stocks as a whole are risky assets, all stocks are not the same. Some are riskier while others are more defensive. Not surprisingly, the riskier stocks tend to do better during times when traders and investors are feeling confident and look to make the most money. When confidence is low, people look to preserve wealth, and the stocks viewed as more defensive (and less volatile) find favor.
The charts below show the performances of the ten sectors in the S&P 500 in the January – February 2012 and March – April 2012 periods respectively. Not surprisingly, the worst performers during March – April were the notoriously cyclical Energy and Materials sectors. Not only do the companies in these sectors supply products and services for which demand will fall sharply during recessions, but their operations tend to be very capital-intensive and carry high operational risks.
Notice that the only sectors to do better during the latter two-month (risk-off) period compared to the risk-on period were Consumer staples, Telecoms, and Utilities. They were shunned when the market sentiment was rosy, but when people started feeling more bearish and wanted protection, they started to put money into these sectors.
The companies in such sectors tend to be stable, less economically sensitive, but low-growth businesses. When the economy’s strong, there are simply better growth opportunities elsewhere. But during difficult times, their downside is limited because they offer typically indispensable products and services that should hold up well even in a recession. Moreover, they offer more generous dividends than their growth-oriented counterparts. When fear aversion is high, and market participants want to pare down their risk exposure, these stocks’ relatively low volatility and dividends become attractive targets.
With risks in Europe mounting yet again, and the US economy showing signs of slowdown, the outlook for 2012 has taken on a decidedly murkier tone than just a few months ago. While it may feel safe to just sell everything, cash yields essentially nothing in today’s low interest environment and you risk missing out on a big reversal if you are on the sidelines. Instead, keep defensive stocks—and their downside protection and high yields—in mind.