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A new way to measure ‘risk-on’ and ‘risk-off’ Add to ...

For anyone who wants to judge whether investors are open to taking risk (known as a ‘risk-on’ market) or adverse to it (‘risk-off’), the performance of consumer discretionary stocks relative to consumer staples stocks has always been a simple indicator.

Because consumer staples are goods that people need regardless whether the economy is expanding or contracting, the makers of these goods are supposed to see their stocks fall less in a downturn. Conversely, when the economy is in full swing, investors should have more disposable cash, and can therefore buy discretionary goods.

Yet that rule isn’t holding as much weight as it once did. Four times in the past 20 years both the consumer discretionary and consumer staples sub-indices have outperformed the S&P 500 . That outcome is odd, because the two shouldn't theoretically be so closely linked. So what’s an investor to do?

Sam Stovall, chief equity strategist at S&P took a look at the numbers to find out why this has happened. In part, it’s because some of the sub-industries embedded in the consumer discretionary sector have lower betas than the market itself, such as apparel retail, home improvement retail and leisure products. Restaurants are also included, and Mr. Stovall points them out as a glaring example.

In the S&P 500, McDonald’s is considered a discretionary purchase, and is worth 14 per cent of the sub-index. Because it’s a fast food chain, the index makers probably assume that families will eat more at home when they’re short on cash (hence, a discretionary purchase). But in our hectic society, eating at home is more and more rare, so McDonald’s may actually do better in a downturn. Although some of its regular customers may eat at home more, other diners will move down market from say the Olive Garden to Mickey Ds. (And who wouldn’t want a McChicken, anyway?)

There is another way to measure risk appetites. S&P has created both a High Beta Index and a Low Volatility Index. The first measures the performance of the 100 S&P companies with the highest sensitivity to market changes, and the second measures the 100 least volatile stocks.

To test these indices, Mr. Stovall looked back over 10 years. Doing so, he found that if you only invested your cash when consumer discretionary stocks outperformed consumer staples (risk-on), your return would be far less than if you invested that money only when the High Beta Index (reconstructed for that period) beat the Low Volatility Index.

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