Blog Posts — February 10, 2022

What investor sentiment was telling us before the market tanked

January 2022 saw one of the highest levels of market volatility since the COVID-19 crash of March 2020. During those 20 trading days in January, the STOXX® USA 500 Index fell by almost 6%. Looking back, a key question for investors is: did we overlook any hints of what was coming and, had we an inkling, what might we have done about it?

Consider what Qontigo’s ROOF Scores had to say about investor sentiment.

In our January 10 post reviewing the performance of the sentiment-aware ROOF portfolios constructed from the Qontigo ROOF Scores (our internal sentiment indicator for markets), we commented that sentiment had been mostly negative in 2021, starting with the inflation tantrum of February that year. As inflation worries weighed on sentiment, most investors began implementing defensive strategies. Applying our ROOF methodology to a long-only Momentum portfolio built on the STOXX® USA 900 Index confirmed the increasing popularity of risk-averse assets throughout most of 2021 (with two short bouts of neutral risk appetite)—and that this risk-averse preference continued, and even strengthened, in January 2022.

When investors are bearish, they adopt risk-averse strategies. As a result, despite the overall strength of the market, the Risk-Off variant of our ROOF portfolios outperformed both the parent index (STOXX® USA 500) and its Risk-On counterpart—the latter by quite a bit—in 2021 (see chart below).

The market turned, and sentiment remained risk-averse in January. This bearish sentiment, which accelerated in mid-December 2021, persisted in January 2022. In fact, out of the 20 trading days in January, the US ROOF Ratio indicated a bearish sentiment on all 20 days. And, as can be seen in the Momentum portfolio chart at the top of this post, risk-averse assets continued to be more popular with investors as the Momentum portfolio took on an increasingly risk-averse exposure.

The STOXX® USA 500 Index fell by 5.9% in January 2022. The Risk-On portfolio, constructed to reflect the implementation of a bullish strategy, fell by more than 10%. In contrast, the Risk-Off portfolio, constructed to capture the returns of a bearish strategy, declined by just 3.3%, helped by a positive supply-and-demand balance for its risk-averse assets (see chart below).

Perhaps this connection between ROOF scores and active returns is not all that surprising, as this sort of market reaction is a familiar story: Increased uncertainty + bearish sentiment = risk-averse implementation. But while critical uncertainty levels may be somewhat subjective, sentiment can be quantified directly from observed investor behavior. This is precisely what the ROOF Scores are designed to do.

We use the ROOF Scores to determine the set of risk-averse and risk-tolerant assets in the market based on the then-current factor exposures to ensure that each asset is appropriately classified at the time. We then use this classification to construct Risk-On and  Risk-Off portfolios to measure the rewards for risk-taking in the market over time.

In 2021 markets rose on the backs of risk-averse stocks. Similarly, in January 2022, it did not pay to be bullish, and the Risk-On portfolio strongly under-performed its parent index. On the other hand, the market rewarded risk aversion with smaller losses for the month. The difference from last year was that the market fell sharply in January.

Investor sentiment is multi-faceted. To efficiently capture the premium associated with sentiment timing, investors need a multi-factor methodology. Popular single-factor low volatility portfolios, such as the Invesco S&P 500 Low Volatility ETF (SPLV), fell by almost 5% in January (-4.8%), offering less protection from the market correction than the Risk-Off ROOF portfolio.

Bottom line, sentiment is a separate risk premium from market timing. The ROOF portfolios are constructed to be beta neutral to their benchmarks but to capture the observable investor behavior that results directly from the implementation of their sentiment. Low volatility and minimum variance ETFs have a negative active beta to their parent benchmarks and can therefore only benefit when markets fall. They strongly underperform in up-markets, even if sentiment is mostly negative during those periods, as in 2021. By not trying to time the market—a very hard thing to do well consistently anyway—but instead by capturing the implementation of investor sentiment, the ROOF portfolios offer a new and significant source of return, quantifiable from observed investor behavior. Sentiment matters. It is observable, and it is harvestable.