by Olivier d'Assier
Investors seemed surprised by the market reaction Monday to news of a resumption of the trade war between the world’s two biggest economies, but should they have been? Using the ROOF™ Scores introduced by Axioma last month[1], we analyzed investor sentiment towards risk taking since the start of the year for the Russell 1000 and the CSI 300 Indices. The results show that the continuation of the Q1 rallies into Q2 of 2019 was unsupported by continued rising positive market sentiment. In fact, investor sentiment had been deteriorating since late February, slowly in the US, but much more clearly in China.
The figure below shows the ROOF™ Scores for the Russell 1000 index since the start of 2019 until Monday May 6th. The top chart shows the cumulative index return (black line), and the five-day moving average for the Risk-Tolerance (green line) and Risk-Aversion (red line) scores. The bottom chart shows the balance between the two sentiments (i.e., risk-tolerance minus risk-aversion). We observe that the risk-tolerance scores had been declining since reaching a peak in early February. The risk-aversion score, meanwhile, had been steadily increasing since late February. This convergence resulted in a ‘sentimental dead cross’[2] on May 2nd (see start of the red zone in the bottom chart). The Russell 1000 index nevertheless continued its upward trend until this week, but as the ROOF™ scores indicate, this rise in the index these past two months was not being supported by an accompanying rise in risk appetite. In fact, indications were that investors were becoming increasingly risk aware.
Looking at the same picture (below) for the CSI 300 index of Chinese stocks[3], we see an even more pronounced and advanced deterioration in investor sentiment since February. We see that risk-tolerance peaked in late February, shortly after the Chinese New Year holidays, and risk-aversion began to rise above its long-term average level of 3.7 on several occasions, resulting in multiple short-lived ‘sentimental dead crosses’, the last of which started in April 26, well before the deterioration in the trade talks was known. In fact, risk-aversion crossed over the one-standard-deviation level on April 26, and risk-tolerance fell below its one-standard-deviation level a day later.
Recall that the concept behind the ROOF™ Scores is that when the balance between risk-tolerance and risk-aversion in the market gets beyond a certain level, the same supply-and-demand pricing mechanics that govern the price of any good kicks-in. If we set that trigger point for a buy or sell signal when risk-tolerance minus risk-aversion is greater than +/- 3.5 and leverage the index portfolio by 30% up or down the day following the signal[4], we would have outperformed the CSI 300 index by 7% year-to-date.
The top chart in the picture below shows the cumulative return for the CSI 300 (black line) and for the RT-RA strategy (Risk-Tolerance minus Risk-Aversion). The bottom chart shows the dates of the Buy (green bars) and Sell (red bars) signals triggered by a greater than 3.5 difference between the two scores. Note that the last Buy signal for the CSI 300 index strategy was on March 21st. Also note that all three Sell signals came in the last 10 days, two of them before Monday May 6th.
Markets had a visceral reaction to the news of collapsing trade talks between the US and China over this past weekend. China’s reaction was much stronger than in other markets, even the US, the other directly affected country. A quick look at Axioma’s ROOF™ Scores for investor sentiment in both markets pointed to heightened sensitivity among investors ahead of this weekend, with risk appetite declining since late February and risk aversion rising steadily in both markets, albeit more rapidly in China where risk-aversion was, in fact, already higher than risk tolerance since last week. Volatility affects investors’ investment decisions at a rational level, while uncertainty affects investors’ sentiment at an emotional level. The ROOF™ Scores were developed to capture the emotional element of risk and complement the Axioma predicted risk with a market timing indicator based on investor sentiment. Both must be used in combination to obtain a more complete view of risk and investors’ appetite for it.
[1] See research paper introducing the ROOF™ Scores here and blog post here.
[2] The death cross is a technical chart pattern indicating the potential for a major selloff. The death cross appears on a chart when a stock’s short-term moving average crosses below its long-term moving average. See Investopedia.
[3] Note that the sharp dips in both the risk-tolerance and risk-aversion lines in the top chart at the start of February are an artifact of the missing dates for the Chinese New Year market closure – please ignore that period.
[4] If the risk-tolerance score is higher than the risk-aversion score by more than 3.5, buy futures to take on 130% of the market return. If the risk-tolerance score is lower than the risk-aversion score by more than 3.5, sell futures to only take on 70% of the market return. When the difference between risk-tolerance and risk-aversion drops back below absolute 3.5, close the position and continue holding the benchmark portfolio (i.e., take 100% of the market return).
