ROOF Highlights — October 19, 2020

Qontigo ROOF™ Score Highlights: Week of October 19, 2020

Potential triggers this week: Final US presidential debate between Trump and Biden. Earnings from IBM, Netflix, and Tesla. Flash PMI surveys for the US, UK, Eurozone, and Japan. US building permits and housing starts, and existing home sales; UK inflation data and retail trade; Eurozone consumer confidence; China Q3 GDP figures; and Japan trade balance and inflation. 

Summary: The divergence between our Style and Sector ROOF variants turned into a convergence on the weak side this week as investor’s risk aversion levels surged in the face of rising new infections across major markets and hopes for a second fiscal stimulus package in the US before the elections (Nov 3) diminished. The Q3 earnings season has so far been unable to convince investors that a rotation rally was feasible as the same sectors seem to still benefit from the current rebound leaving others behind. Rising new infections across Europe and the US have already seen calls for renewed safe distancing measures, delaying hopes for a more broad-based recovery. The lack of clarity on crucial events such as the US election results, Covid-19 vaccine availability, US and EU fiscal stimulus packages, and a post-Brexit trade agreement between the UK and the EU should continue to translate into higher risk aversion levels for investors despite improving economic data.

US Investor sentiment weakens further with rising uncertainty and new infections. 

Diminishing hopes for a fiscal stimulus package ahead of the elections on November 3 has caused a turnaround in our Style ROOF ratio and the divergence we noted last week with our Sector ROOF ratio has ended with the former now playing catch-up to the latter’s increasingly risk-averse mood (top chart). The STOXX USA 900 index was unable to beat its previous high being powered by only a handful of (the same) sectors. Investors have been looking at this Q3 earnings season for signs other sectors would soon join the recovery rally but rising new Covid-19 infections and the potential for renewed safe-distancing measures is hampering this rotation trade. 

The Sector ROOF saw a surge in risk aversion sentiment last week while risk tolerance continued to decline (bottom chart). This is bringing the Sector ROOF ratio (green line in top chart) closer to the border between Neutral and Bearish. Last week’s drop triggered another SELL signal, the second since late August. With a minimum of three weeks to go before an election result, a deteriorating risk appetite, and a rising rate of new infections, US investor’s cognitive bias is rapidly turning negative and could trigger an over-reaction on the down side in the event of a worse-than-expected news. The fat lady is not singing yet, but she is definitively warming up. 

Rising infections lead to sharply rising risk aversion levels for European investors.

After the longest stretch of positive sentiment, European investors turned neutral for the first time since April two weeks ago. Last week, as the Covid-19 narrative turned sharply negative again, so did investor sentiment. Both ROOF variants dropped deeper into Neutral territory last week (top chart), putting an end to this month’s market rally which began in late September.

Investor’s risk tolerance (green line in bottom chart) has been declining sharply, and risk aversion (red line in bottom chart) has been since the end of September. This increasingly negative cognitive bias denied the STOXX Europe 600 the risk appetite it needed to break above previous July and August highs. News of renewed social distancing restrictions to stem this second wave of infections will fall onto increasingly bearish ears and are likely to increase profit-taking pressures ahead of the year-end and the winter season. The STOXX Europe 600 index has been basically flatlined since retracing half of its march losses by early June, and a further three months of positive sentiment was not enough to push it higher. Can it hold onto its gains if sentiment turns bearish in the next week or so?  The drop in sentiment has already caused a SELL signal on October 8 for both variants.

Sentiment deteriorates further for both Global and Asia ex-Japan investors.

Global investors followed the rest of the world into the Neutral zone last week, with the Style ROOF variant (blue line in top chart) finally crossing over from bullish to neutral. Meanwhile, the Sector ROOF (green line in top chart) continued to weaken deeper into the Neutral zone as risk aversion rose past the level of risk tolerance for the first time since the start of September. This weakening sentiment once again, as it did in September, halted the market’s efforts to break previous highs.

Sentiment in Asia ex-Japan lags other markets but has also broken below the bullish zone into the neutral one last week as risk aversion rose sharply.  As noted in earlier reports, risk tolerance had started to decline in late September, but risk aversion remained low until last week. The gap between the two remains in favor of risk tolerance but has narrowed from 2.0 to just 0.5 now. If risk aversion levels in this part of the world continue to rise, matching those in other markets, the remaining positive balance between the demand and supply of risk will quickly close. Markets have been ignoring this deteriorating sentiment and may have become vulnerable to a retracement on unexpected negative news.