Markets may have started to recover from last week’s fall, but investor sentiment remains on a downtrend. Sentiment had ended the previous week bearish in four markets, bullish in only one. Last week, amidst the attempted rebound from markets, investors’ mood worsened still, ending bearish in seven markets, bullish in none. Only Australians are holding on to a positive mood for now. Investors who only three weeks ago were bullish in both the UK and China, now seem to have given up hopes, ending very negative in the former and neutral in the latter.
What Happened: The world, which had been increasingly predictable until July 20th, quickly became unpredictable after July 21st. On July 20th, return forecasts were based on a victory for Donald Trump in November, a soft landing for the U.S. economy, a recovery in corporate earnings boosted by AI, and the ongoing efforts to negotiate a peace deal between Hamas and Israel for the return of hostages. The war in Ukraine was at a stalemate, with claims that Trump could settle it in a day if elected, and expectations were high that the Fed and ECB would start cutting interest rates in the fall. However, on July 21st, everything changed. Biden dropped out of the race, Harris began to surpass Trump in the polls, reports surfaced questioning the sustainability of the AI business model, hostilities escalated in the Middle East, and the U.S. job market unexpectedly weakened, prompting fears of a recession.
The Trigger: For two decades, the Bank of Japan (BoJ) had been a central bank in search of influence. On July 31st, it found more than it bargained for. A 15 basis points rate hike - only the second in 20 years - had an unexpected and dramatic impact, triggering the unwinding of the largest carry trade the world has ever seen. The lesson: you can’t assure speculators it’s safe to bet on something for 20 years, then suddenly pull the rug from under them.
Current State: Investing has always been about returns, a metric so ingrained in our understanding of the stock market that risk often goes unnoticed—until returns turn sharply negative, prompting a search for the reasons why. Return and risk are like the Yin and Yang of investing, each serving as the template for the other. Return dictates the formation of risk; and risk in turn shapes the potential size of return. Currently, investors are recalibrating their return forecasts to account for higher-than-average risk and lower-than-average predictability. While markets may have stopped falling, fear will linger in the collective unconscious of investors until predictability returns.
What’s Next: Market crashes, like earthquakes, are often followed by smaller aftershocks - what would life be without the occasional surrender to impulse. If predictability doesn’t return, investors will continue adjusting their portfolios, further de-risking, and requiring speculators with higher risk tolerance to take the other side of the trade, likely at a discount (the bottom charts in seven of the markets below indicate a very large and negative imbalance between the demand and supply for risk right now). Predictability may be slow to return, as tensions in the Middle East persist, Ukraine has just entered Russian territory, and the U.S. Presidential race remains too close to call, sparking fears of a contentious and prolonged transition with potential economic consequences. For now, sentiment remains too fragile and prone to downside overreaction in the event of further uncertainty. There is just too much mud on the windshield making it difficult for investors to see what lurks ahead. Best to pull over into a rest area and wait for visibility to return.
Potential triggers for sentiment-driven market moves this week
US: CPI, PPI, industrial production, consumer confidence, and speeches by Federal Reserve officials. Earnings from Home Depot, Cisco Systems, Walmart, Applied Materials, and Deere & Company.
Europe: UK unemployment, inflation, GDP growth rates, industrial production, and retail sales data. Economic Sentiment survey for Germany, industrial production and GDP (second estimate) for the Eurozone.
APAC: China retail sales, new yuan loans, and unemployment data. Japan Q2 GDP figures.
Global: The primary focus will be on the upcoming US inflation report and whether it provides the Federal Reserve with justification to cut rates sooner and more aggressively than anticipated. Meanwhile, attention on the geopolitical front will center on Russia's response to the recent Ukrainian incursion, as well as Iran's response to the assassination of a Hamas leader on its territory, which it attributes to Israel.
Note: green background = bullish, red background = bearish
Changes to investor sentiment over the past 180 days for the markets we follow:
How to Interpret These Charts:
Top Charts:
The top charts illustrate the ROOF ratio, which represents investor sentiment. This ratio is depicted in green on the left axis, while the cumulative returns of the underlying market are shown in black on the right axis. Key reference lines include:
A horizontal red line at -0.5 (left axis), marking the threshold between negative sentiment (-0.2 to -0.5) and bearish sentiment (< -0.5).
A horizontal blue line at +0.5 (left axis), indicating the boundary between positive sentiment (+0.2 to +0.5) and bullish sentiment (> +0.5).
A horizontal grey line at 0.0 (left axis), around which sentiment is considered neutral (-0.2 to +0.2).
Bottom Charts:
The bottom charts display the levels of risk tolerance (green line) and risk aversion (red line) within the market, representing investors' demand and supply for risk, respectively. Key insights include:
When risk tolerance (green line) exceeds risk aversion (red line), more investors are willing to buy risk assets than there are investors willing to sell them at the current price. This scenario forces risk-tolerant investors to offer a premium to entice more risk-averse investors to trade, thereby driving markets upward.
Conversely, when risk aversion (red line) surpasses risk tolerance (green line), the market dynamics reverse.
The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio shown in the top charts, reflecting the sentiment of the average investor in the market.
Blue Shaded Zone:
The blue shaded zone between levels 3 and 4 for both indicators signifies a reasonable balance between the supply and demand for risk in the market. When both lines remain within this blue zone, the market is considered stable. However, when both lines move outside this zone, the significant imbalance in demand and supply for risk can lead to overreactions to unexpected news or risk events.
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