Is Risk-On/Risk-Off Back?


After a solid day yesterday, stocks opened lower this morning, with the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average down 0.17% and 0.24%, respectively, as of 10 a.m. EST.

The short view
On Jan. 25, when the S&P 500 had just finished capping a seven-day winning streak, I asked whether a secular bull market was underway. Since then, stocks have alternated between winning and losing days every day except for a single two-day losing streak last week -- and that back-and-forth looks set to continue today. Even as the correlation between individual stocks has declined markedly -- last Wednesday, the CBOE S&P 500 Implied Correlation Index with a January 2014 maturity hit its lowest value since its inception in November 2011 -- we appear to be witnessing a resurgence in our old friend "Ro-Ro" -- the risk-on/risk-off dynamic.

Of course, Ro-Ro -- or, more accurately, the risks that drive it -- never really left at all. As the Financial Times'Wolfgang Munchau wrote on Sunday:

A lot of people have become more optimistic about the eurozone, in some cases even euphoric. Hardly a day passes by without someone declaring the end of the crisis. But its two most dangerous aspects are unresolved -- zombie banks and macroeconomic adjustment.

Investors got a taste of that this week as a financial scandal engulfed the ruling party in Spain, roiling the Spanish stock market and pushing Spanish government bond yields to a six-week high. This was almost certainly a major contributing factor in Monday's U.S. stock market losses: The S&P 500's 1.2% decline was the largest since November.

Let's not forget that we have our own home-grown Ro-Ro drivers, too. For example, although it has not made the headlines in a couple of weeks, the fiscal cliff remains unresolved. These factors will be enough to produce periodic risk-on/risk-off spasms, even as markets normalize and stock pickers begin to reap the rewards -- this is par for the course.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him @longrunreturns. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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