The US market has been broadly aligned with investor sentiment since early October (see Figure 1 below), with both rising in tandem as investors celebrated the news of a phase one trade deal between the US and China, ending a two-year trade war that had rattled markets. Then news of the coronavirus outbreak in China hit the front pages, bringing back vivid memories of the SARS outbreak that crippled the region in Q1 2003 and caused global markets to contract by about 12% that quarter.
Since January 10, investor sentiment has been on a straight downward trend (see blue line in Figure 1). After initially declining together with sentiment for 10 days (January 20 to January 30), markets chose to ignore investors’ declining risk appetites and return to their pursuit of consecutive new historical highs during the next 20 days (see black line in Figure 1 below). This defiance of investors’ rising risk aversion led to a large disconnect between the return on risky assets and the actual appetite driving it in the first 20 days of February. What made this disconnect even more striking was the fact that 61% of the fall in investors’ risk appetites was due to rising levels of risk aversion, and only 39% due to declining levels of risk tolerance. In other words, investors’ fears were rising faster than their greed was declining.
Figure 1: Cumulative return for the US-All Caps market portfolio (black line), Qontigo ROOF RatioTM (blue line) – From October 10, 2019 through February 21, 2020
This last observation is an important clue as to what may follow, as our research has indicated that investors tend to act more quickly and decisively on fear rather than greed. When investor risk-aversion levels reach a certain threshold, investors tend to de-risk their portfolios by selling risky assets, they tend to do so in a disorderly fashion, and (almost) at any cost. Conversely, when risk tolerance levels reach a certain threshold, investors tend to increase the risk in their portfolios by buying riskier assets, they tend to do so in an orderly fashion, and they do it over time, while keeping an eye on costs. The latter is very much like patrons slowly filling the seats in a movie theater; the former more like their response when the fire alarm goes off.
As we have seen with Monday’s reaction, the market cannot ignore divergent investor sentiment for long, as it leaves it vulnerable to media reports that may suddenly tip investors’ risk aversion beyond that threshold and send them running for the exits.
Now that Monday’s swift market reaction is past, what lies ahead for markets? In Figure 2 below we look at the same sentiment indicator during the SARS outbreak. We see a very similar pattern to the current one in Figure 1 above. What followed the period of disconnect between the market and investor sentiment in January was an 8% market correction between the January 14 high and the March 31 low.
If the market events of 2003 surrounding the SARS outbreak, the 12.5% rise in GOLD (the premium safe have asset class), the 55 bps drop in bond yield (10-Year USTB), or the 100% rise in the VIX (the fear gauge), are any guide, Monday’s correction isn’t close to getting us to equilibrium in the supply and demand for risky assets. More to come.
For more information on the ROOF scores we use to measure market sentiment as described above, see here.