What a difference uncertainty makes! Last year, 2020, the uncertainty caused by the COVID-19 pandemic was replaced by the certainty of monetary and fiscal stimulus, the somewhat messy but essentially positive US presidential election results, and the clear sector allocation choice between the so-called pandemic profiteers versus the pandemic sufferers. Even the multiple vaccine news in early November pointed the way to a rotation trade with bright neon lights. This made 2020 the year of Go-Big-or-Go-Home.
The first half of 2021 has been a very different story. Inflationary pressures early on took the certainty of monetary stimulus away. A tie in the US Senate put fiscal stimulus in doubt. And a deadly second wave of COVID-19 infection over the winter, together with the arrival of new and more virulent variants of the virus, disrupted both the supply and demand side of the economic growth equation, sending the rotation trade in reverse. Investors spent the first five months of the year worrying about inflation and the future direction of monetary policy, and the last three worrying about slowing economic growth. This made the first half of 2021, the (half-)year of investing defensively.
Using our Sector ROOF Scores, Qontigo’s investor sentiment indicator, we developed a methodology to construct both a Risk-On and Risk-Off variant of the STOXX USA 500 index. These sentiment-driven portfolios help us measure the rewards the market pays for risk-taking. The Risk-On portfolio represents a risk-tolerant investment strategy that loads on sectors with a positive ROOF Score. The Risk-Off portfolio represents a risk-averse investment strategy that loads on sectors with a negative ROOF Score.
The charts below show the cumulative performance of the STOXX USA 500 index (black line), the Risk-On portfolio (blue line), and Risk-Off portfolio (green line), measured against the right axis, and the daily ROOF Ratio for the US market (orange bars), measured against the left axis.
The first chart shows the performance of the three portfolios in 2020. We can see that even including the COVID-19 crash of March, 2020 was a Risk-On year (the Fed made sure of that). During 2020, the index portfolio was up 22%, versus a gain of 31% for the Risk-On portfolio, and a gain of (just) 9% for the Risk-Off portfolio. Clearly going home in 2020 (i.e., having a risk-off strategy) didn’t pay as the market was strongly rewarding risk-taking that year (at the urging of the Fed). There were 253 trading days in 2020, investors spent 109 (43%) of those being bullish according to our ROOF Ratio (orange bars), and only 59 (23%) days being bearish – most of those during March and early April. The rest of the time 85 (34%) days, they were neutral but more positive than negative.
The chart below shows the performance for the same three portfolios up to July 31st, 2021. We can see that the uncertainty caused by the potential removal of monetary stimulus, wavering economic growth forecast due to the ongoing third wave of new infections from the Delta variant of the COVID-19 virus, and persistent inflationary pressures, are forcing most investors to adopt a risk-averse strategy. The increasing popularity of risk-averse sectors has made them big winners this year as the market clearly did not reward risk-taking in the first half of 2021.
During the first seven months of 2021, the STOXX USA 500 was up 17%. The Risk-Off portfolio was up 18.4% and the Risk-On portfolio almost 13%. During the 145 trading days to July 31st, investors have been bearish for 36 (25%) of those, neutral (but mostly negative) for 102 (70%) days, and bullish on only 7 (5%) days. Will investor sentiment remain risk-averse in for the remainder of 2021 and will the market continue to reward risk aversion over risk tolerance?
A continuously rising market as we have seen since March 23rd 2020, does not mean risk-taking is being consistently rewarded. The market will reward risk-taking differently at different times, as the charts above demonstrate. Sometimes it is better to be risk-averse than to be risk-tolerant. At other times being risk-tolerant comes with extra rewards. Most times, it is best to adopt an investment strategy that is aligned with the aggregate investor sentiment.
The ROOF Market portfolios, with their Risk-On and Risk-Off variants, were constructed to capture the ‘Sentiment’ factor return in the market as a proxy for the rewards available to investors for risk-taking. These charts show a strong alignment between how investors feel and the type of investment strategy they select. They also show alignment between sentiment and how risk is being rewarded in the market. When most investors are bearish, a risk-averse strategy out-performs, and when most investors are bullish, a risk-tolerant strategy does better. Investor sentiment is the not-so-secret mistress of markets. Understanding its nature, quantifying it, and treating it as an additional systematic source of return (a.k.a., a factor), can help investors capture more of the market’s reward for risk-taking.
 The neutral zone is defined as a ROOF ratio between -0.5 and +0.5. A positive number below +0.5 denotes a slightly positive, but not yet bullish sentiment. Conversely, a ROOF Ratio below 0 but above -0.5 denotes a slightly negative bias but not yet bearish sentiment.