Tuesday, July 9, 2013

Cyclical Stock Divergences and Risk Taking Fades

I have discussed the divergence between the track of the S&P 500 and the relative price of the Morgan Stanley Cyclical Index (ticker CYC) and the Dow Jones US Consumer Services ETF (ticker IYC) from time to time. The indicator's importance stems from the thesis that the cyclical stocks will disproportionately benefit(falter) from an environment of increased(decreased) investor risk taking. Essentially, a rising relative line shows cyclicals outperforming non-cyclical stocks, indicating a rising risk propensity. Increased willingness to take on risk should translate into higher equity prices and vice versa. The following is the latest chart for the S&P 500 and the relative price of the CYC and the IYC (relative price risk measure, RPRM).



That is quite a divergence. However, I will concede that the relationship between the value of the S&P 500 and the RPRM may not have always held. Additionally, the divergence may also be an artifact of the change in relative value over time. To adjust for any value differences, the below chart looks at the same data as in the above chart on a rolling 6-month percentage change basis.



I believe the above chart indicates the fairly strong relationship between the S&P 500 and the RPRM. A couple of items jump out at me looking at this chart however. First, divergences do not occur often. Second, the S&P 500 and the RPRM tend to have the same directional shape at any given point in time. Additionally, a positive(negative) 6-month change in the RPRM typically corresponds with a similar S&P 500 change.

The last two points make the current period odd. Directionally, the progression of the percentage in the S&P 500 and the RPRM diverged starting in late 2012. Additionally, the RPRM, on average, has printed a negative 6-month change since the beginning of 2012. This is versus a positive rolling 6-month return on the S&P 500. Apparently, investors are buying equities despite trepidations toward risk or at least risk as measured by the RPRM.

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