Risk-on Risk-off vs. Qualitative Market Environments
By Kristi Henderson, CPA/PFS, Madrona Financial Services and Co-Portfolio Manager of the AdvisorShares Madrona ETFs (FWDB, FWDD, FWDI)
A “Risk-on Risk-off” environment exists when prices fluctuate relative to investors’ tolerance for risk. In this environment, stocks and sectors tend to be highly correlated. Volatility is often higher during these times as a result of investor uncertainty, similar to what we’ve seen in recent months. Many investors decide to go “all-in” or “all-out,” often through buying or selling an index. Indexes are simple to trade and their market cap weighting is appealing during fearful times. Mega-cap stocks tend to be more familiar household names which provide comfort to investors. As a result of investors flocking to indexes during risk-on risk-off environments, it’s more difficult for active strategies to outperform the index during these times. However, as a risk-on risk-off environment matures, stock prices have a tendency to gravitate away from fair pricing based on company valuations. This is largely a result of an abundance of index investors that overweight the largest companies, thus driving those prices up despite company valuations that may not warrant a price increase.
Alternatively, qualitative investing occurs when investors have confidence in the market. During this time, investors reallocate towards higher yielding stocks and are more willing to invest in less familiar companies in search of larger returns. When doing so, they tend to look at company valuations and allocate their investment decisions based on multiples such as price to earnings ratios. As a result, this often causes investors to gravitate away from the mega-cap stocks which are often overvalued as a result of indexes inflating these stock prices, thus resulting in a price correction. This environment occurred during 2013 and as a result, the Russell 2000 largely outperformed the Dow Jones Industrial Average. When 2014 rolled around, the qualitative environment swiftly gravitated towards risk-on risk-off where it has remained, aside from a short-term qualitative investing period during early 2015.
Looking forward, we anticipate a more qualitative environment as uncertainties in the political arena and the Fed’s decision to raise interest rates subside. We anticipate more certainty in these areas to increase investor confidence and lead us into a more sustainable qualitative environment than what we saw in early 2015. If the Fed doesn’t act as a result of poor economic indicators, we could be stuck in this risk on risk-off environment well into 2016.