Risk On vs. Risk Off

It’s a Bull Market and we had another up week for the major averages.

Funny how that works.

What stood out this week was the Small Caps.

Maybe they read my post about the “Iron Giants” and took it personally.

Either way, they crushed it, helped along by “inflation” numbers that boosted expectations for Fed rate cuts in September.

I usually keep things technical, but it’s worth noting: smaller companies carry more risk.

Lenders demand higher rates when they borrow. Cheaper capital means those pipedreams and early-stage ideas can survive longer and maybe even grow into profitability and viability.

Investors piling into these names isn’t a sign of fear.
It’s a sign of hunger for risk.

It’s still early in this development, but this is where intermarket and intramarket relationships shine.

They help us gauge whether investors are in risk-on or risk-off mode.

Here are 4 of my favorite ratios for that.
Let’s get into it.

One of my personal favorites is discretionary stocks vs. staples stocks.

• Discretionary stocks (XLY) = restaurants, hotels, cruise lines, luxury goods. People only buy these if they feel confident and have extra income.

• Staples stocks (XLP) = groceries, tobacco, detergent. People buy them no matter what the economy is doing.

When discretionary outperforms staples, it tells us the consumer is healthy. A healthy consumer is a hallmark of a Bull Market.

Right now, discretionary stocks are sitting at all-time highs while staples churn sideways. Clear message: risk-on.

*Note - In this ratio chart I utilize equal weight ETFs so we can get a fair representation from each stock. The market cap weights can be dominated by a few names. A nuance that provides an additional layer of clarity.

This one is pure logic.

• High Beta (SPHB) = stocks that move more than the market (a beta of 1.5 moves 1.5x the S&P).

• Low Volatility (SPLV) = stable stocks that smooth out drawdowns, but also lag in strong uptrends.

When would investors prefer high-beta stocks?

When they believe markets are going higher, not lower. Low-vol names are for defense.

Currently, this ratio sits near its highs and importantly, both sides are going up in absolute terms.

That’s healthy participation. Another vote for risk-on.

This one comes from my accounting background. Credit tells the truth early.

• HYG (High Yield Bonds) = lower-quality corporate debt. Investors only buy junk bonds when they’re confident about growth and defaults staying low.

• IEF (Treasuries) = the safest debt in the world. Investors run here when they’re nervous.

When HYG outperforms IEF, it means risk appetite is alive in the credit market.

Historically, credit spreads lead equities and tightening spreads confirm confidence, widening spreads are often the first crack before stocks follow lower.

Right now, HYG/IEF is firm. Credit is confirming what we see in equities: risk-on.

*Note - Credit is just a fancy term for the ability to borrow money. When the gap (spread) between what investors demand from “junk” companies and the U.S. government is small, it’s a healthy credit market and a risk-on backdrop. When that gap widens, it’s usually an early warning of trouble. This ratio started to fall before the S&P 500 at the start of the year, a nice warning sign for those paying attention.

This one gets less attention, but it’s one of the most robust gauges of stress.

• VXX tracks short-term VIX futures (front two months). Highly sensitive to market shocks.

• VXZ tracks mid-term VIX futures (4th–7th months). Much steadier, reflects long-term expectations.

  

When the ratio VXX/VXZ < 1, (ratio dropping) it means short-term volatility is lower than longer-term volatility.

That’s the normal “contango” state of the VIX curve and a supportive, risk-on backdrop.

When the ratio spikes above 1, the curve flips into backwardation.

Short-term fear overwhelms long-term expectations.

That usually marks periods of stress and equity drawdowns.

Right now, this ratio sits comfortably below 1.

Another sign the market is in a risk-seeking regime.

*Note - Look at the spike around the tariff tantrum, there was a premium on short term volatility relative to longer term.

My goal is to develop robust investment frameworks.

That means we never take one of these ratios on its own as a reason to make a decision.

We want to weigh the evidence, look at them in aggregate, and see which way the scale is leaning.

Right now, these four ratios alongside this pop in Small Caps are all lined up in the same direction.

That doesn’t mean there won’t be volatility or negative headlines.

But it does mean the weight of evidence suggests it’s still a time to be more opportunistic than fearful.

Is that a surprise? No. We’re in the midst of a Bull Market.

But keeping a close eye on these ratios ensures we’ll know where to look when risk-seeking becomes the exception, not the rule.

Until then……the risk is not taking any.

🎥 Thompson Two Cents Live | Ep. 1 – ALL GAS, NO BRAKES

I go live every Friday at 5 PM EST.

This week kicks off a new monthly segment: ALL GAS, NO BRAKES

No pontification. No endless “what ifs.” Just pure setups.

Each chart gets 1 minute. Straight to the point.

🚀 Throw it on 1.5x speed and let it rip.

👍 Give it a like. It’s the easiest way to show me some love.  

The Sunday Stalk List

I’ll be breaking down setups I like right now.

If you like clean charts, clear setups, and tactical insights — this one’s for you.

The early feedback has been 🔥 and we’ve already tagged some big winners.

Here’s last week’s edition.

Cheers,

Larry Thompson, CMT CPA

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