Investor confidence is on the rebound in the US and Japan, as market sentiment shifts from bearish to a more neutral stance. This positive change has also nudged the sentiment for Global Developed markets up a notch, improving from bearish to negative. However, investors still hold a bearish view in Global Developed ex-US Markets, Global Emerging Markets, and Asia excluding Japan. Meanwhile, sentiment in Australia, China, Europe, and the UK remained neutral, unchanged from the previous week.
August began with a proverbial warning from the land of the rising sun about crowding risk in the carry trade, and reminding us that investors who panic together, sell together. However, sentiment ended the month on a more optimistic note, defying its bearish start.
Despite elevated levels of both volatility and correlation lingering in the background, investors with an eye for a bargain decided to focus on discounted valuations instead, eventually restoring indices back to their prior highs with their purchases. It was as if the crash had occurred in their blind spot. Their mind needing the market to still be an actor in their success story, and so they filled-in the blanks from August 5th with reasons to buy, classifying talks of over-valuation and rising downside risk as little lobbed grenades of jealousy from investors sitting on the sidelines.
Volatility and correlation are two crucial concepts in investing, but they serve distinct masters. Both are involved in gauging investor sentiment, yet volatility is often associated with feelings of fear or confidence, while correlation is more often associated with the collective mood swings of panic or thrill among investors. Both the predicted risk and the average pairwise correlation among constituents of major benchmarks remain elevated since August 5, and indicative of the potential for above-average downside moves in markets. Correlation is more important when thinking about portfolio risk than volatility, which can be easily hedged, yet most investors consider it peripheral - not the stuff but the stuffing in the market.
Risk aversion continues to dominate investor sentiment in most markets, indicative of a low willingness to speculate in the face of a still uncertain near future. Anticipation of at least two quarter-point reductions in the Federal Reserve's interest rates by year-end has already been factored into market prices. The forthcoming US employment data for August, due this Friday, will either reinforce these expectations or suggest the need for adjustments.
On the political front, US investors are punting pricing-in any potential risks associated with the upcoming Presidential election on November 5th, the outcome of which remains too close to call. Following the recent electoral events in the EU and France, it was Germany’s turn to face the rise of a far-right party. This week's market reactions will be indicative of whether investors will adjust their risk assessments based on the nationalist AfD party's victory in the German regional elections, mirroring the market's response to similar events in France previously.
This week should be a quiet one sentimentally speaking, as the earnings reporting season has concluded, and the United States observes Labor Day Weekend with markets there closed on Monday. The week's only significant data release is scheduled for Friday morning US time. In the absence of major risk events, market sentiment is likely to revert to a neutral level, reflecting a cautious stance ahead of the forthcoming US elections but supported by expectations of ongoing interest rate cuts in the US and Europe over the coming year.
Potential triggers for sentiment-driven market moves this week
US: Manufacturing and Services PMI data and the August Jobs report.
Europe: Manufacturing and Services PMI, and retail sales data for the Eurozone.
APAC: China manufacturing PMI, balance of trade, and inflation data. .
Global: With the earnings season behind us, macroeconomic news will retake the lead this week, but with nothing on the docket until Friday’s US Jobs report, it should be a quiet week.
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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