So much for autumn being the worst time of the year for the stock market. Despite the political wrangling in Washington, investors continue to embrace higher-risk assets with open arms.
While this might be a longer-term cause for worry, for now it’s a sign of the robust underlying health of the market. Consider these five telling signs of investors’ hearty appetite for risk:
- Small-caps outperforming large: Even as the S&P 500 Index fell all the way to its lower trendline last week and has failed to retake its September high in the subsequent rally, both mid-caps and small-caps broke out to new highs yesterday. iShares Russell 2000 ETF (IWM) and SPDR S&P MidCap 400 ETF (MDY) have gained 10.6% and 8.4%, respectively, since June 30, compared to 5.9% for the SPDR S&P 500 ETF (SPY).
- High-beta trouncing low-beta: The evacuation from stable, dividend-paying stocks amid the increase in Treasury yields has been accompanied by a stampede into the higher-risk areas of the market. Since bond yields began their ascent on May 2, the PowerShares S&P 500 High Beta Portfolio (SPHB) has gained 18.2% and beaten the 0.4% return of PowerShares S&P 500 Low Volatility Portfolio (SPLV) by a monumental margin.
- Momentum darlings are unstoppable: Even last week’s sell-off wasn’t enough to dampen the enthusiasm for this year’s triple-digit winners. Stocks such as Netflix (NFLX), Tesla (TSLA), Facebook (FB), Priceline (PCLN) and Best Buy (BBY) have rebounded strongly in recent days, outpacing the broader market and building on their massive gains of the past six months.
- Highest-risk countries surging: While the rebound in emerging markets has received the most attention — iShares MSCI Emerging Markets ETF (EEM) is up 12.6% since the beginning of September — the real story might be in the European periphery. Since July 1, iShares MSCI Italy Capped ETF (EWI) and iShares MSCI Spain Capped ETF (EWP) have rocketed 27.8% and 31.2%, respectively. The Global X FTSE Greece 20 ETF (GREK) has performed even better, gaining 39.3%. This indicates that investors are actively seeking out the countries that will provide the highest beta in their effort to play the recovery in Europe’s growth.
- The bond market is dancing to the same tune: The quest for risk isn’t limited to stocks. Recent bond-market performance has favored the highest-risk market segments. Since June 30, in fact, the best-performing market segments have been corporate and high-yield bonds in the developed-international and emerging markets. Bond investors might not want to take on interest-rate risk at this point, but they certainly aren’t being bashful when it comes to credit risk.
What does all of this tell us about the markets here? Most likely, the preference for higher-risk assets is driven by the convergence of ample global liquidity, renewed concerns about “safe assets,” and — perhaps most important — the need for lagging institutional money managers to play catch-up. The well-documented underperformance of mutual funds and hedge funds in 2013 has created a cohort of managers that needs to take on added risk for a chance to finish the year ahead of their benchmarks. Mega-cap stocks aren’t going to get the job done, but small caps and the Teslas of the world will.
The performance gap between high- and low-risk assets also provides investors with a clear reference point for the market’s health. As long as the five trends noted above continue, stocks in general are likely to remain in good shape. Conversely, any slippage in these trends is a warning signal — particularly if it’s accompanied by other potentially negative signs, such as lower volume, weaker breadth, or technical breakdowns.
The bottom line: Take advantage of these trends as long as the opportunity presents itself, but be wary. When the tide turns on a risk trade, the outcome is rarely benign.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.