Around market peaks as the economy heads into recession, the stock market will often trade sideways for 6-9 months, almost as if the market is attempting to make up its mind. But this type of behavior can also occur at other times, even when the economy is in a healthy state.
The price of equities are determined by investors participating in the stock market. Markets fall when more people are selling than buying. This can occur when buyers feel uncertain about buying more equities, or because sellers are uncertain and decide to unload equities they hold. Either way, the market drops because the risk-tolerance of market participants is falling.
At market peaks, not all investors will lose faith in the stock market in the same instant. It takes many months for bearish investors to outweigh bullish ones, driving the market down in the process. In addition to the market trading sideways during these times, it stands to reason there would be other symptoms of the massive shift from bull market to bear market. Such a large shift can't possibly occur without causing other side-effects which we can measure.
No all stocks are created equal. Some stocks rise more when the economy is strong, and drop more when the economy is in trouble. Other stocks are less sensitive to economic forces. These stocks rise and fall less dramatically with changes in the economy.
As uncertainty builds among investors, it stands to reason that the volatility of traditionally risky equities would increase more than the volatility safe equities.
It is this change in the relative volatilities of these two types of equities that forms the basis for a market risk-tolerance indicator. The indicator is formed by comparing the volatility of risky vs safe equities. While risky stocks typically have higher volatility than safe ones, this difference narrows when market participants are confident, and widens when they have more uncertainty.
The Risk-Tolerance indicator is formed by casting this difference in the range between positive and negative 1.0, where negative values indicate a bearish lack of risk-tolerance.
The chart below illustrates the Risk-Tolerance indicator for the past 17.5 years.
The chart shows the indicator drops precipitously at market peaks, as well as other times when fear overtakes greed. During the bear market in 2000, investors demonstrated alternating bouts of fear and confidence as the market bounced its way down to the lows in Q402.
The 2007 bear market was much more terrifying, and there was no such delusion of confidence. Additionally, during the recovery there was much talk of a double-dip recession. This can be seen by the large effect this had on risk tolerance during 2010-2011.
Interestingly, the precipitous market drop in 2010 didn't seem to faze investors, but when it was followed by a second sharp drop in 2016, they got a bit rattled by the experience.
It should be noted that this is merely an indicator of risk-tolerance. It does not attempt to predict whether the market is at a peak or not. It measures the amount of confidence or fear the market is exhibiting at any point in time. Fearful markets paired with a strong economy are typically an investing opportunity, while fearful markets paired with a weak economy are far more dangerous.