The US market fell 3% overnight and the implied volatility from the VIX shot up to 22%. At 22%, this represents an expectation of a +/-1.4% intraday move two days out of three (i.e., assuming normally distributed returns). But yesterday was not a ‘normal’ day. There is less than a 1.6% probability of seeing a market move of +/-3% given this implied volatility, so what happened? We use Axioma’s ROOF Scores for market sentiment to attempt to see how this greater-than two standard deviation event could have happened and, more importantly, how it might happen again, and again…We find that the current lack of risk appetite helped fuel the decline.
Institutional investors fall into three temporal categories: short, medium, and long-term. Short-term investors tend to rebalance intra-week on any given day. Medium-term investors tend to rebalance monthly, and long-term investors quarterly. We match the ROOF scores to each investor type by looking at a 5-, 20-, and 60-day moving average of our daily sentiment scores. Market commentators ascribed yesterday’s US market rout to a yield curve inversion between the 10-year and 2-year treasury yield—a historical forecaster of recession down the road. So, we start our investigation by looking at our ROOF scores for the long-term investors in the US market using the US All Caps variant of our US Axioma Market Portfolio (AXUS-LMS).
The chart below shows the cumulative return for the US market in black (RHS) and both components of our ROOF Scores, the Risk Tolerance Score in green (LHS) and the Risk-Aversion Score in red (LHS), using our 60-day moving average to align them with long-term investors’ quarterly decision making.
The two sub-periods highlighted in green on the chart show rising markets that were ‘supported’ by rising levels of risk tolerance (green line) and declining levels of risk aversion (red line). In fact, in April 2019, the combination of a consensus of no more Fed rate hikes and an imminent trade deal between the US and China gave sentiment quite a boost. The two black ellipses on the chart also show that the continuing market rallies of August-September 2018 and June-July 2019 were not ‘supported’ by sentiment. During both late rallies, long-term sentiment had reversed and risk tolerance was declining as risk aversion was rising, leading the two scores to invert into a bearish ROOF signal prior to each market correction.
What about medium-term investors in the US market? The chart below shows the same ROOF scores for medium-term sentiment using a 20-day moving average of our daily ROOF scores. The sub-periods highlighted in green again show rising markets that were ‘supported’ by rising risk tolerance within this second investor group. Periods in between do not seem ‘supported’ by risk appetite in the group. We also see that sentiment turned on the 15th of July this year, with risk tolerance starting its decline, while risk aversion begun to climb leading to an inversion on August 5th.
Finally, when we look at the ROOF scores for short-term investors, we see that they, too, had become slightly more risk averse than risk tolerant since mid-July. The chart below shows the ROOF scores with a 5-Day moving average to match the weekly rebalancing cycle of short-term institutional investors. Focusing on the quarter-to-date chart below we see that risk tolerance among this group began to decline on July 16 and reached an inversion point on the 21st of that month. Since then, the aggregate ROOF score (risk tolerance minus risk aversion) has remained in negative territory.
Given the lack of risk appetite in the three major investor groups noted above, it is evident that the supply of risky assets would have dwarfed demand. The few risk-tolerant investors still willing to add to their risk levels would have had an easy time extracting large price discounts from the numerous risk-averse investors looking to de-risk their portfolios. The yield inversion (among other factors) provided them with just the right incentive to rush for the exit, given their state of risk aversion when it occurred. As of this writing, sentiment remains overwhelmingly negative and it will take more than a rising consensus on future Fed rate cuts to turn it around for long-term investors. Nothing short of a favourable resolution to three important geopolitical risks (i.e., the US-China trade war, Brexit, and the Japan-South Korea squabble) will be able to turn the tide on that one.
Axioma’s ROOF™ Scores Explained – The ROOF Scores were created to quantify market sentiment—in other words, bullish or bearish? ROOF is an acronym for Risk-On/Risk-Off market conditions. ROOF Scores are calculated from the factor returns to eight style factors from Axioma’s short-horizon fundamental factor risk models, plus two indicators of changing market volatility. Together, these 10 metrics are used to compute risk-tolerance and risk-aversion scores. To quantify the overall market sentiment, we simply take the difference between the two (risk-tolerance minus risk-aversion).