How to Invest in a "Risk-Refusal" Rally

Cyprus had an agreement with its creditors in hand early this morning, and that was enough for U.S. stocks to open in the black -- but not enough to keep them there. The S&P 500 fell 0.3% on the day, while the narrower, price-weighted Dow Jones Industrial Average lost 0.4%. Reflecting the losses, the VIX Index , Wall Street's fear gauge, was up today but only by 1%. (The VIX is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.)

Welcome to the "risk-refusal" rally
Are there pockets of exuberance in the capital markets? Absolutely. I've repeatedly highlighted high-yield bonds as a prime example of that exuberance. On the whole, however, investors -- particularly individuals -- have returned to the stock market only grudgingly and with extreme caution. With 2008 seared in investors' collective memory, they are still demonstrating extraordinary risk aversion, which is why I'm referring to the current bull market as a "risk-refusal rally."

Perhaps you think this is nonsense. If so, here's more evidence of this phenomenon, on a global scale, no less: From their Oct. 2011 low, the MSCI Emerging Markets Index gained 22% through last week, compared to 33% for the MSCI All World Index. According to Bloomberg, that is the first time that emerging market equities have lagged developed markets' in a global share rally since 1998. Conventional thinking has it that emerging markets are higher risk than developed markets; historically, they've certainly been higher "beta" (i.e., more volatile than the world index) -- just not in this rally.

So, how does one invest in a "risk-refusal rally"? If Cyprus has taught us anything, it is that the hierarchy of risk is not a sole function of asset class. Apparently, large depositors at Cyprus banks thought bank deposits were sacrosanct -- that illusion is going to cost many of them somewhere between a quarter and two-fifths of their assets.

Investors need to revisit their notions of risk: U.S. Treasury bonds with microscopic yields are not "low risk," for example. Conversely. at the other end of the spectrum, investors consider bank shares as "high risk" due to past losses suffered. As I noted this morning, that aversion has kept even large mutual funds from returning to the shares of Bank of America and Citigroup , but where everyone sees risk, the contrarian sees potential opportunity.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned. You can follow him on LinkedIn. The Motley Fool owns shares of Bank of America and Citigroup. 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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