Last week, investor sentiment remained steady, balancing positive developments from China and encouraging inflation news from the US and Europe against deteriorating situations in Ukraine and the Middle East. Chinese authorities have finally detailed their stimulus package, but it seems to be addressing the wrong problem - feeding a non-hunting bear instead of a starving wolf. This suggests that further measures will be needed soon. Japan has a new Prime Minister (candidate) which should maintain the status quo with the US and China. And in the US and Europe, investors appear to have shrugged off the positive inflation news, shifting their focus to unemployment and overall economic health. As a result, a miss on this Friday’s Jobs report is expected to have a greater impact than previous ones.
Despite the escalating conflicts in Ukraine and Gaza, developed markets continue to reach new record highs. Why is this happening? The explanation is straightforward: investor sentiment remains unaffected by unpredictable events. Since the outcomes and timelines of these wars are unknown, they cannot be forecasted. Investors prefer to focus on predictable factors, such as specific events at specific dates. Instead of worrying about “something unknown happening at an uncertain time,” they concentrate on “this event occurring on that date.” In essence, investors do not respond to the unknown, only to the temporarily hidden.
Currently, investors are primarily focused on three key concerns: The Fed achieving a soft landing for the US economy, The ECB preventing a hard landing in Europe, and the results of the US elections on November 5th. These events have meet the criteria of predictable outcomes and known timelines, whether through data releases or election results. Now, investors need to assign probabilities to these outcomes and build their portfolios accordingly.
One might expect a market like the US, where the S&P 500 has reached 42 consecutive record highs in 2024, to be dominated by bullish sentiment. However, out of the 187 trading days this year, investors have been bullish on only 11 days (between mid-June and early July) and positive on another 31. In contrast, they have been bearish on 33 days and negative on another 31 days, with the remaining 81 days being neutral. 2024 is increasingly resembling 2021, a bear market in a bull’s clothing, as investors have consistently favored defensive sectors and styles, showing only a hesitant willingness to speculate.
The situation in Developed Europe mirrors that of the US, with consecutive highs driven by just two bullish days (the first two days of the year) and 12 positive days out of 194 in total. In contrast, European investors have been bearish for 44 days and negative for another 86 days, with the remaining 50 days being neutral. Although the economic outlook in Europe has been more concerning than in the US, this hasn’t prevented markets and valuations there from continuing to rise.
The key to understanding this paradox lies in the focus of investors over the past two years. They have primarily been concerned with inflation, economic strength, and interest rate trends. Recently, answers to these macroeconomic concerns have emerged, dispelling their worst fears and validating their best hopes. As these worries fade, we can expect investor sentiment to realign with market performance, shifting attention from the overall economy to the earnings potential of individual companies.
Potential triggers for sentiment-driven market moves this week[1]
US: Manufacturing and services PMI data, speeches by several Fed officials, and the August Jobs report on Friday. Possible strike by some 85,000 doc workers potentially closing some 100 East and Gulf Coast ports.
Europe: Eurozone inflation data, and UK Q2 final GDP numbers.
APAC: China’s manufacturing and services PMI data ahead of Golden Week holiday. Japan’s Tankan large manufacturers index for Q3, consumer confidence, retail sales, industrial production, unemployment data, and minutes from the BoJ’s last meeting.
Global: Monetary policy in key economies as well as global economic strength.
[1] If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.
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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