A little-known indicator of risk perception among stock investors is flashing caution.
For starters, it reveals what may be an investor obsession with the domestic economy and earnings, perhaps at the expense of caution for the global outlook.
That indicator measures the relative risk level of small-cap versus large-cap stocks. And when it leans too far one way or the other, it historically has signaled a change in the broader stock market.
Unlike large- and presumably stable-company shares, small-cap stocks are perceived to be riskier, hence more volatile. So in a typical relationship, the small-cap-focused CBOE Russell 2000 Volatility Index RVX, -5.96% almost always runs higher than the S&P 500-based CBOE Volatility Index VIX, -8.63%
The relative risk between the two, called the premium, is actually a ratio between RVX and VIX, but is reported as a percentage of VIX. It can climb (or drop) to extremes, and did recently; for instance in early April that reading climbed to near 37%, as shown in the chart below, higher than where it stood the last time it steadily rose then peaked in November.
Last August it peaked above 40%, perfectly coinciding with the beginning of a market plunge that was triggered by a devaluation in China’s currency.
At times of high market stress, VIX tends to rise more than RVX, shrinking or even eliminating the premium. Notice that over the last few sessions, the RVX/VIX ratio has moved dramatically, crossing above 36%, then falling off when an oil-inspired rally lifted stocks, before spiking to back above 30% in a quick turnaround.
Russell Rhoads, director of program development for the Options Institute at the Chicago Board Options Exchange, which licenses many of the volatility measures, explained: “When that ratio gets too high, it usually means that investors are a lot more concerned about domestic economy than the global or macro outlook.”
“Earnings and outlooks from companies will be telling,” said Rhoads, adding nobody was bullish right now.
“The perception of risk is rising, despite the rebound in the [broader] market. When value stocks outperform growth stocks, as they did since the start of the year, it suggests there is not much confidence in the economy,” he said.
The chart shows that over the past year, moves in the RVX/VIX premium ratio above 30%, and especially above 40%, preceded a rollover that was followed with a rise in broader-market volatility.
The small-cap Russell 2000 RUT, +1.18% up 1.2% on Wednesday, rebounded 16% from its Feb. 11 low. It is down 2.4% year to date, while S&P 500 SPX, -0.55% is up 1.1% over the same period. Small-caps underperformed large stocks in 2014 and 2015.
Rhoads, who refrained from making forward statements, said “the RVX/VIX premium has been a good signal for justifiable market concerns in the past.”
“After years of low volatility, we are transitioning to a high-volatility regime and the process can last three to four years,” he said.