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February 13, 2017

The Fear Factor

by Amareos.

A few weeks back we highlighted an interesting shift in the crowd’s view towards US future inflation trends. Specifically, we noted that the reflationary meme that quickly emerged following Trump’s victory in November’s election had developed an audible hiss[1]. Well, in the intervening weeks this hiss has only increased in volume – see exhibit below.

Moreover, the rebound in US economic growth sentiment that accompanied the jump in future inflation sentiment (albeit significantly more muted in magnitude – it only just made it into positive territory) has also stalled. Combined, these two crowd-sourced sentiment indicators suggest that the rise in “animal spirits”[2] that has propelled US equities higher, symbolically taking the Dow above the 20,000 mark, is fading.

Exhibit 1. Crowd-sourced Sentiment Future Inflation & Growth – US



That said, the crowd-sourced sentiment that has most attracted our attention recently is the move in the US equity market Fear indicator (specifically the S&P500). As can be seen in the exhibit below, this indicator peaked on election day at 85. Given the index is calibrated to lie within a 0-100 range, such a reading is rather elevated by historic standards. In the weeks immediately following Trump’s victory, and no doubt reinforced by the swift market rebound (the subject of last week’s Market Insight[3]), fear towards US equities dissipated strongly. That is, until January 14. Since then the US equity Fear indicator has risen, and rather significantly.

Exhibit 2. Crowd-sourced Sentiment Equity Sentiment – US



What is readily apparent, even from a cursory eyeballing of the above exhibit, is that a marked rise in crowd fear towards US equities has, historically, been a reliable harbinger of future equity market weakness. Conversely, when the Fear indicator is at historically elevated readings and begins to subside, such as was the case just after the presidential election, it is typically a harbinger of future equity market strength[4]. Right now, given this sentiment’s current trajectory, it should be a concern to equity market bulls.

To illustrate this more concretely, consider the following exhibit. It shows all the occasions over the last two years when the US equity Fear indicator has shown upward momentum similar to that just observed (a ten-point increase over a ten-day period) plotted against S&P500 drawdowns.

Exhibit 3. Crowd-sourced US Equity Fear Momentum vs. S&P500 Drawdowns



Of the eight occasions seen since January 2015 when the momentum of our US equity Fear indicator witnessed a similar increase to that just observed, over the following month the S&P500 fell below the initial level in all but one case: September 2016. The average maximum drawdown in the month following a positive Fear momentum signal was 2% and the highest maximum drawdown was 4.8% (as occurred in August 2015). In some instances, such as last summer, the market correction was significant but short-lived[5]. So, the rise in Fear sentiment is not necessarily a signal of trend change for Wall Street, but it is worth noting for those interested in mitigating near-term market risk.

What makes the rise in the US equity Fear indicator especially interesting is that it has occurred at a time when the VIX has not only been declining, but has fallen to unusually low levels by historic standards. As per our tweet last week:

Exhibit 4. A Recent Tweet



The VIX, which measures implied equity market volatility, is commonly labelled the stock market “fear gauge”. However, this is a misnomer. Correctly considered the VIX is simply a measure of investor demand for options. Such demand could very often be reflective of investor fear about a stock market decline. But, like any market price-based indicators it also reflects numerous other factors (market liquidity etc) wholly unrelated to investor fears or apprehensions. Hence, while the VIX and the crowd-sourced US equity Fear indicator are reasonably well correlated over time – as one would naturally expect – they can, and do, periodically diverge.

While the jump in crowd’s fear towards US equities may prove unfounded (anything is possible in terms of future market trends), combined with the shifts in US future inflation and economic growth sentiment mentioned at the outset, the consistent message is that the public has become more circumspect regards the economic and financial impact of Trump’s presidency than at any point since the election.

Furthermore, bear in mind that the rise in US equity market Fear sentiment occurred before last Friday’s controversial executive order. The imposition of a temporary US travel ban for people from seven predominantly Muslim countries was messy (it was unclear if green card holders or those with dual nationality from these countries were exempt) suggesting haste over good design – never a good policy trait!

It also went down extremely poorly on the international stage. For example, in the UK more than a million people have signed a petition – ten-times the required threshold for getting the topic debated in parliament – calling for Trump’s planned state visit this summer to be cancelled; so much for the special relationship! We find it extremely hard to envisage that such actions will dampen rather than exacerbate geopolitical worries about Trump’s policies – never a market friendly outcome (as evidenced by Monday’s sell-off and one-point jump in the VIX).

Of course, a US President with a penchant for firing off extremely controversial executive orders[6], rising crowd fear, elevated geopolitical worries and the benign market outlook suggested by the (still) relatively low level of the VIX  may reflect how events unfold. Nevertheless, it is a mix that doesn’t sit right with us[7]. Moreover, given the level of the VIX the cost of downside hedges remains relatively inexpensive (at least for the time being); something that doesn’t happen too often.

Finally, what are the implications of such crowd sentiment shifts for one of the major focal points for investors – the long predicted bond bear market?

The back-up in US government borrowing costs over the past few months has certainly reinvigorated the vigilantes frustrated by their numerous and repeated failures to call the end of the bull market.

Looking at the components of the benchmark 10-year US Treasury yield, from the summer low of 1.50%, the 100bp increase breaks down into a rough 70-30 split between break-even inflation and real (or inflation adjusted yields). The former is now in line with the Fed’s mandated target of 2%, and with public perceptions of future inflation and growth on the wane, the macroeconomic gravitational pull on yields should be downwards.

That said, some commentators have suggested that the move up in US Treasury yields may not be solely driven by the actual (or perceived) evolution of US economic growth or inflation, but may instead be reflective of a higher risk premium being demanded by investors[8]. The basic premise underlying this hypothesis is that Trump’s business history suggests a predilection for using debt to its maximum and has included four Chapter 11 bankruptcy filings. One way we can test the validity of this hypothesis is by examining trends in crowd-sourced sentiment towards debt default (one of the component indices in our daily sentiment-based Political Risk Indicator).

As can be seen in the final exhibit, at no time since the summer low in nominal US Treasury yields have public perceptions towards debt default in the US increased, as one would anticipate if US Treasury yields were rising as a result of investors demanding a higher risk premium. So, plausible and appealing as the hypothesis sounds, there is scant supporting evidence for it, and combined with the shift in the crowd’s view towards Wall Street, it suggests the bond vigilantes will have to continue to bide their time.

Exhibit 5. Crowd-sourced Sentiment – US Debt Default



Sentiment Analytics are based on MarketPsych Indices

[1] See:

[2] No concrete economic policy proposals have been outlined yet.

[3] See:

[4] The rationale can be considered as analogous to extreme sentiment reversals which were the subject of last week’s Market Insight – see footnote 3 above for the link.

[5] We warned as much in a Market Insight published last May – see:

[6] Rather like his tweets!

[7] As does the cover of this week’s Barron’s magazine entitled “Next Stop Dow 30,000”. Business magazine front covers have a long history as contrarian indicators – something we have noted on more than one occasion in the past – see:

[8] Alternatively, speculation of a buyers-strike by Gulf-based sovereign wealth funds – significant holders of US treasuries – in protest to the ban may have encouraged some traders to mark down US government bond prices. However, having worked in one of the leading funds in the region we find it hard to envisage that such a reaction would be triggered. Trump and his team have made it clear that this was not a ban on Muslims entering the US (although this was part of the campaign rhetoric). Moreover, the travel ban does not directly impact the populations of countries with such entities.

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