To The Moon

This edition of the ROOF highlights will take a lookback at sentiment in 2024 and a peak into 2025.

Potential triggers for sentiment-driven market moves in 2024 and 2025[1]

• The major source of risk and swings in sentiment in 2024 was political change: More people voted in elections in 2024 than ever before with voters representing about 54% of the global population and 60% of global GDP going to the polls across more than 70 countries.

• The major source of risk in 2025 will be  policy implementation by newly elected populist leaders in a multipolar world: Many markets worldwide will experience significant changes in policies and regulations. In some instances, these changes will be quite dramatic. A new and potentially more disruptive trade war could arise between the world’s two largest economies, leading to a swift decoupling of the global supply chain. This would create economic headwinds and pose a significant challenge for political leaders.

[1] If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.

In 2024, the three biggest source of mood swings for investors were first, monetary policy decisions by key central banks (Fed, ECB, BoJ, BoE), second, political change via election results, and third, geopolitics (ongoing wars in Ukraine and Gaza). The outlier was China where regulatory intervention and the repeated promises of stimulus packages heavily influenced investor sentiment, especially in September.

Globally (across the ten markets we follow), sentiment was only mildly more positive (and by extension less negative) than the long-term average. Given high monetary policy uncertainty, voters in countries representing 60% of Global GDP opting for radical change, and two ongoing wars, investor sentiment was surprisingly resilient. This resilience paid off. In 2024, investors were positive (positive or bullish) 38% of the time, versus a long-term average of 34%, negative (negative or bearish) 36% of the time, versus a long-term average of 39%, and neutral 30% of the time versus 27% over the long term.

Notables:

• Throughout our history (going back to 1997 for all markets and 1982 for the US), Australians have always been the most positive investors, feeling positive or bullish 54% of the time on average, and negative (negative or bearish) 17% of the time, but this optimism was even more pronounced in 2024 with the average Australian investor feeling positive or bullish a whopping 81% of the time, and never feeling negative or bearish at any time during the whole year, earning them the gold medal of most positive investor in 2024.

• Chinese investors have historically been the biggest pessimists in our history, feeling negative or bearish 60% of the time on average, but the combination of post-Covid reopening hopes and repeated promises of stimulus packages have kept them expecting good news most of the year, earnings them second place in our 2024 ranking by being positive (positive or bullish) 58% of the time and negative (negative or bearish) only 17% of the days.

• European investors slipped from their long term rank of 6th for positive sentiment, to last (10th) in 2024, spending less than 7% of the days feeling positive or bullish – no doubt a reflection of the political uncertainty following elections or votes of no-confidence in the UK, EU, Germany, and France.

• US investors dropped from 4th place in our history to 8th in 2024, although that was mostly due to spending more days feeling neutral (43% of the time versus 28% historically)  than positive (24% versus 35% historically), as the number of negative days (33%) was also below the long-term average (39%). No doubt the rise in uncertainty was caused by the chaotic election campaign in the runup to November 5th.

• In 2024, UK investors experienced negative sentiment on only 15% of days, which is half of their long-term average of 31%. They were also slightly more positive than usual, with 49% of days showing positive sentiment compared to the long-term average of 40%. Additionally, they spent more days in a neutral mood (35% vs. 28%). This more positive outlook likely reflects the smooth transfer of power during their parliamentary election.

• Typically, Japanese investors distribute their sentiment fairly evenly, with about a third of their days being positive (32%), neutral (35%), or negative (33%). However, in 2024, they spent nearly half of the days (49%) in a positive mood, while only a quarter of the days were either neutral or negative. This shift reflects the balance between the positive impact of the weakening Yen and the negative influence of the Bank of Japan’s sudden hawkish monetary policy in August.

• Global Emerging Market investors are generally more risk-tolerant than their counterparts in Global Developed Markets. Historically, their positive sentiment ranks second only to Australians, and their negative sentiment ranks 9th, just behind Australia’s 10th place. However, in 2024, positive sentiment among Global Emerging Market investors dropped to 7th place, with only 29% of days being positive or bullish compared to the historical average of 44%. Conversely, they exhibited negative or bearish sentiment on 39% of days, up from the usual 29%. This shift occurred despite Chinese investors feeling better in 2024 than historically and can be attributed to the higher-for-longer US interest rates and the strong USD, as most of the Emerging world’s corporate debt is in USD.

• Sentiment among Global Developed and Global Developed ex-US markets remained similar to their long-term trend. Both continued to have a slight negative bias, reflecting their bigger exposure to global risk events, geopolitics, and global trade. We do not see that trend changing in 2025.

What to expect in 2025:

The most significant change for global markets in 2025 will be the return of President-elect Donald Trump to the White House on January 20th. Trump, trailing a reputation for changing peoples' lives -  some legislatively, others fiscally, and some via executive orders - will hold the world's interest without once soliciting its sympathy. Loyalty won't cook the dinner, but it will get you a seat at Trump's table. For some leaders, this will mean that it’s time to bow and play Trump. Others will resist, retaliate even.

Structurally, the process of constructing a portfolio to accurately capture an investment thesis is prone to errors; it relies on noisy estimates of return, volatility, and covariances. Not even the price of each holding is known a priori. In a highly unpredictable geopolitical world, the size  of these errors increases, lowering the signal-to-noise ratio for investors, making portfolio management akin to  navigating a ship at night through a stormy sea without a reliable map or compass.

Investors secretly want and need the market’s approval of their forecast, and on occasion it gives it to them. At other times, it will rearrange their investment thesis in extremely colorful ways. In the end, every return on investment is a function of the risk taken. Sometimes the risk pays off, and sometimes it doesn’t. That’s part of the risk. Realizing this is risk management in itself.

Consider the market events surrounding the last FOMC meeting in the US on December 17, 2024. Investors didn’t merely hope the Fed would stay on track to cut rates four times in 2025; they expected it. This expectation was confirmed by the bullish ROOF score (0.54) on the preceding day. However, the next day’s 3-standard deviation fall[2] following the news that there might be only two rate cuts instead of four, highlighted the significant disappointment among investors. Simply put, a denied expectation hurts more than a denied hope.

In 2025, investors will have to learn to accept what they cannot control and learn that they control a whole lot less than they thought. It will be a year filled with “I knew it!” and “Wait, what just happened?”. Geopolitical uncertainty will not only have investors searching for their bearings, it will be continuously bearing down on them, at times triggering  trichotillomania – the urge to pull one’s hair out.

Globally, newly elected politicians will face pressure to implement the populist policies they campaigned on in 2024. This will occur against a backdrop of increased political violence and acts of terrorism, another global trade war, and ongoing military conflicts in Ukraine and the Middle East. Foreign relations and trade policies are likely to become more transactional, with political leaders operating without a rule book.

This will create a risk regime characterized by a volatility rollercoaster requiring investors to develop the separate skills needed to succeed in both a low and a high volatility environment. When volatility is conspicuously low, it will lure some investors into making bad decisions. Low risk does not mean no risk, that’s because  when volatility seems like it’s up to nothing, no good’s usually next.

Speculators love low volatility. It says ‘yes’ to all their dreams, ‘yes’ to leveraging up, ‘yes’ to not hedging, and gives them what they want. It's a shoeless summer walking on the beach. Conversely, they don't like high volatility, because it says ‘no’ to everything they expected and instead gives them what they feared. It's a shoeless winter walking in the snow.

From time to time, speculators will become famous for taking positions contrary to popular opinion, accepting the vitriol that follows, and not straying from an inner strength they call “conviction”. However, in an increasingly volatile geopolitical environment, replicating such success will often prove illusory. A straightforward factor-based performance analysis will reveal that what is often perceived as skill was actually just random luck. Beware of hubris.

To navigate 2025 successfully, investors will need to make stress testing their new best friend and regularly seek second (risk) opinions from different risk models. Changes in volatility and correlations can turn a small crack in your investment thesis into a chasm. Avoid high-stakes speculation – trying to turn a little money into a lot - and make prudent investing – trying to prevent a lot of money from becoming a little – your new moto. Bet only when the odds are in your favor as an unexpected loss in one day can quickly snowball into two, leaving you saying, “Best of five, Fortune. Best of five!”. As the next day brings a third ‘unexpected’ loss, you’ll find yourself pleading, “Best of seven! Please, please, please, I beg you, best of seven!”

Remember, Fortune may be the Goddess of luck, but she is also the Sister of Fate.

Source: Axioma ROOF Scores

Changes to investor sentiment during 2024 for the markets we follow:

How to Interpret These Charts:

Top Charts:

The top charts illustrate the ROOF ratio, which represents investor sentiment. This ratio is depicted in green on the left axis, while the cumulative returns of the underlying market are shown in black on the right axis. Key reference lines include:

• A horizontal red line at -0.5 (left axis), marking the threshold between negative sentiment (-0.2 to -0.5) and bearish sentiment (< -0.5).

• A horizontal blue line at +0.5 (left axis), indicating the boundary between positive sentiment (+0.2 to +0.5) and bullish sentiment (> +0.5).

• A horizontal grey line at 0.0 (left axis), around which sentiment is considered neutral (-0.2 to +0.2).

Bottom Charts:

The bottom charts illustrate the distribution of the ROOF ratio for each market throughout 2024. The color-coded bars represent different sentiment days:

• Red and Orange bars: Bearish or negative sentiment days (a.k.a., “negative” days).

• Navy blue and light blue bars: Bullish or positive sentiment days (a.k.a., “positive” days).

• Green bars: Neutral sentiment days (a.k.a., “undecided” days).

Key metrics on the right of the chart include:

• Mean, standard deviation, median, minimum, and maximum values in 2024.

• Note that the long-term mean for all markets is 0.00, with an average standard deviation of approximately +/-0.55.

Insight from the data:

Sentiment is a mean-reverting metric, meaning it tends to return to its average over time. Investors’ emotions typically cycle through stages: from bullish to positive, to neutral, to negative, to bearish, and back again. When sentiment is either bullish (navy blue bars) or bearish (red bars), there is a significant imbalance between the supply and demand for risk assets in the market. This imbalance can lead to price  disruptions in the event of a negative or positive surprise. Both the navy blue and red bars indicate a mood swing greater than one standard deviation away from the mean (neutral) sentiment, suggesting a strong confirmation bias among average investors at that time. This bias increases the likelihood of an overreaction to risk events. The good news, as indicated by the green line in the top charts, is that investors typically do not remain in these extreme states of greed or fear for long.

[1] If sentiment is bearish/bullish, a negative/positive surprise on these data releases could trigger an overreaction.

[2] The Vix opened on the 18th at 15.57%, corresponding to expectations of a +/-0.97% price move on the day. The actual move was -2.90%, a 3 standard deviation event from the opening expectations.