by Olivier d'Assier
Potential triggers for sentiment-driven market moves this week1:
- US: Services PMI, factory orders, and foreign trade data.
- Europe: Eurozone final Q2 GDP numbers and July retail sales. Industrial production in France and Germany, as well as German inflation rate for August.
- APAC: Q2 GDP data and the RBA interest rate decision in Australia. Services PMI data in China.
- Global: Low volatility means most investors have let their guard down for the time being. Not many known unknowns are on the docket for this week, so any trigger will have to come from unknown unknowns. Those usually come from the extreme weather or geopolitical side of the ledger.
Insights from last week’s changes in investor sentiment:
Investor sentiment has settled in the neutral zone across all markets we follow, unable to resist the call from low volatility levels, but unwilling to directionally commit amidst an uncertain macro picture. The only thing investors can confidently say about returns right now is that they’d like more of it. Last week’s Jackson Hole gathering of major central bankers didn’t really clarify things for them either. Released statements weren’t so obviously wrong. But then again, they weren’t so obvious, period.
Sentiment is saying “We’re not sure“, but if the penalty for being wrong is so small, do we need to be? Low volatility readings come with a gold sticker on the front cover that says, “SMALL LOSSES!” – just two little words, but oh how they spark the imagination.
Market volatility is low because investors all seem to agree on the direction of markets and which (few) stocks to own. They are shrugging off the lack of clarity from an uncertain macro and geopolitical picture because the penalty for getting it wrong is predicted to be minor. Losses are predicted to be small because risk models are predicting low market volatility. Have we settled into a certain interrogational circularity?
Small projected losses are a magnet for speculators and the stock market is a fine place for them to gather. It has plenty of the only kind of people who can stand speculators – other speculators – and plenty of the only kind of people speculators can get any real investible information from – other speculators.
In the US, for the month of August, the Crowding factor in our Trading-horizon risk model which measures the popularity of a stock with hedge funds, had returns that were in the 98th percentile of our history (going back to 2006). Additionally, the Short Interest factor which measures investors’ interest in shorting a particular stock, had a return that was so negative, it was a 4th percentile event in our history. Are we witnessing the wisdom of the crowds or the ignorance of the masses?
The best way to have a good risk outcome is to avoid taking unnecessary risks. But that would deprive speculators of the potential for undeserved returns – these are occasionally useful and always a pleasure. But, almost as bad as risks that get ignored, are returns that get too much attention and turn into a bubble. To paraphrase Pascal, all mispricing comes from investors being unable to sit still in a market where losses are predicted to be small.
As a risk management analyst, you could say that I am a professional coward; I make my living by being terrified about expected losses. What scares me now is that there seems to be a new wave of fearless money on top of the old prudent one, and that the complacency that comes with low volatility forecasts means any risk event will be amplified by the element of surprise.
Changes to investor sentiment over the past 180 days for the markets we follow:
How to read these charts: The top charts show the ROOF ratio (investor sentiment) in green (left axis), against the cumulative returns of the underlying market in black (right axis). The horizontal red line at -0.5 (left axis) represents the frontier between a negative sentiment (-0.2 to -0.5) and a bearish one (<-0.5), and the horizontal blue line at +0.5 (left axis) represents the frontier between a positive sentiment (+0.2 to +0.5) and a bullish one (>+0.5). Around the horizontal grey line at 0.0 (left axis), sentiment can be considered neutral (-0.2 to +0.2).
The bottom charts show the levels of both risk tolerance (green line) and risk aversion (red line) in the market. These represent investors’ demand and supply for risk. When risk tolerance (green line) is higher than risk aversion (red line), there are more investors looking to buy risk assets then investors willing to sell them (at the current price), forcing risk-tolerant investors to offer a premium to entice more risk-averse counterparts to take the other side of their trade, which drives markets up. The reverse is true when risk aversion (red line) is higher than risk tolerance (green line). The net balance between risk tolerance and risk aversion levels is used to compute the ROOF ratio in the top charts, representing the sentiment of the average investor in the market.
The blue shaded zone between levels 3-4 for both indicators, represents a reasonable balance between the supply and demand for risk in the market. Conversely, when both lines are outside of this blue zone, the large imbalance in the demand and supply for risk can lead to an overreaction to unexpected news or risk events.
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Asia ex-Japan:
Australia:
China:
Developed markets:
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Emerging markets:
Europe:
Japan:
UK:
US:
1 If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.
