A look at an old friend: Risk

There are many ways that we measure "risk" in the market. Most of it is actually not risk, but measures of volatility that people ascribe to risk. But things like the Beta and trends in the VIX are used to describe the risk environment (the volatility environment). I have talked about the VIX many times (such as Impressive VIX and VIX-Sentiment). And I am interested in another topic today.

Equity Risk

Looking at the movement of Small Caps relative to Large Caps can be very informative. Small Caps are much more volatile and during the good times can juice your returns (and during the bad times can crash like, well ... small caps during 2008).

But these moves are based on herd behavior. The herd is always very bullish at market peaks and very bearish at bottoms. So looking at when Small Caps are richly valued relative to Large Caps describes when bullishness becomes uber-bullishness and can be the precursor to a trend change. This is another indirect sentiment measure that I like.

In particular, when I look back over the last few years, the ratio of the Dow Industrials to the Russell 2000 reaches a certain level when trend changes occur. The ratio is at that same level currently. And the market is saying "I AM SUPER BULLISH!!!". Lots of talk about going to new highs is funneling money into more speculative issues, like junk bonds, homebuilders and yes small caps.

Which says to me: The risk environment is extreme.

Good luck out there.