Author: Olivier d'Assier, Qontigo
Potential triggers for sentiment-driven market moves this week1:
US: Federal Reserve’s bank stress test results, consumer spending data, PCE price index.
Europe: Inflation releases for the Eurozone, Germany, France, Italy and Spain, and the ECB Forum on Central Banking (will include Fed Chairman Powell).
APAC: China Manufacturing PMI, Japan’s industrial production and retail sales data.
Global: Any new development in the war in Ukraine and the Russian infighting, and its impact on energy prices.
Insights from last week’s changes in investor sentiment:
Investor sentiment continued to decline in all markets we track except in the UK, where investors remained bullish and, in the US, where sentiment became strongly positive but failed to turn bullish for the second time this month. Two of the ten metrics in the ROOF methodology are related to the level of risk in the market (the other eight are linked to fundamental style factors). Remove, or worse, reverse those and sentiment would be much weaker than it seems. Volatility has been trending down for all markets since the start of the year, with predicted risk for the US market falling by 40%. These low risk readings mask the fact that trading volume has been concentrated in a few sectors (big tech for the US and big luxury for Europe), valuations (PE ratios) are above long-term averages, and uncertainty about the macroeconomic environment remains high.
So far this year, sentiment has generally been softer than market returns would suggest. Even after being rescued by regulators following the banking crisis in March, and relieved by a last-minute deal that kept the repo man away from US treasuries during the debt ceiling crisis in May, sentiment has only been timidly playing catch-up to the resilience of markets. Still, the narrow breadth of volume indicates that most investors remain only cautiously optimistic at best, feeling that, though it probably has its moments, the average day spent on the sidelines is bound to beat the average day spent in the market with losses. Let’s face it, “low risk” doesn’t mean “no risk,” and given the high macro uncertainty these days, any extended market rally that doesn’t contain at least one 10% correction just hasn’t extended itself very far.
The case made by bulls is that inflation was the only threat to markets and that it is on its way down. That’s a bit like saying that a deer’s only enemy is a pair of headlights. Uncertainty about the fate of the economy remains high, despite its own insistence that it is doing fine. Central bankers remain adamant about the need for further rate hikes, forcing adherents of the pivot theory to stuff their fingers in the dike even as the floodwaters of doubt wash over it. Low volatility readings are tempting investors to take risks and see the pivot glass as half full, even while it is lying shattered on the floor. The pivoteers are starting to sound like the boy who cried wolf, and their inability to accurately predict the timing of an eventual pivot is making their theory about as useful to investors as those studies claiming that people who wear socks to bed are likely to live five hours longer than the rest of us. Low volatility is the only reason they still have some listeners, but the decline in sentiment reflects a healthy skepticism on the part of investors that this rally could end in a big “Bonfire of the volatilities”.
Note: green background = bullish, red background = bearish
Changes to investor sentiment over the past 180 days for the markets we follow:
How to read these charts: The top charts show the ROOF ratio (investor sentiment) in green (left axis), against the cumulative returns of the underlying market in black (right axis). The horizontal red line at -0.5 (left axis) represents the frontier between a negative sentiment (-0.2 to -0.5) and a bearish one (<-0.5), and the horizontal blue line at +0.5 (left axis) represents the frontier between a positive sentiment (+0.2 to +0.5) and a bullish one (>+0.5). In between those two lines, sentiment can be considered neutral (-0.2 to +0.2).
The bottom charts show the levels of both risk tolerance (green line) and risk aversion (red line) in the market. These represent investors’ demand and supply for risk. When risk tolerance (green line) is higher than risk aversion (red line), there are more investors looking to buy risk assets then investors willing to sell them (at the current price), forcing risk-tolerant investors to offer a premium to entice more risk-averse counterparts to take the other side of their trade, which drives markets up. The reverse is true when risk aversion (red line) is higher than risk tolerance (green line). The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio in the top charts, representing the sentiment of the average investor in the market.
The blue shaded zone between levels 3-4 for both indicators represents a reasonable balance between the supply and demand for risk in the market. Conversely, when both lines are outside of this blue zone, the large imbalance in the demand and supply for risk can lead to an overreaction to unexpected news or risk events.
Asia ex-Japan:
Australia:
China:
Developed markets:
Developed markets ex-US:
Emerging markets:
Europe:
Japan:
UK:
US:
1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.
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