Global equities have rallied more than 70 per cent from their trough last spring, so you don’t have to look far for signs of froth in markets. The recent GameStop episode highlighted the fragility which exists in pockets of the market, such as popular equity shorts. The same applied to dollar shorts in currencies. Both groups were recently short squeezed.
This week’s Chart Room looks at how, despite the ructions in some corners of the markets, sentiment remains broadly risk-on. But the latest readings from Fidelity International’s proprietary Risk Aversion Indicator (RAI), developed by our Multi Asset team, bear watching.
The RAI is a cross-asset sentimental signal, covering equity, bonds, commodities and foreign exchange. Its inputs include prices, credit spreads and implied volatility data. Aggregating these into a single indicator gives a high-level view of where risk sentiment is relative to history; a score below zero indicates risk-on sentiment, while above zero indicates risk-off.
Currently, the score hovers around -1.0. That suggests investors are clearly biased towards risk-on positioning, but still not to the levels reached during the last two market peaks (which hit readings of around -1.3).
What risk sentiment tells us
While the market rallied aggressively after the correction last year, risk sentiment (viewed through the RAI) was relatively subdued because implied volatility remained elevated. This was particularly true in equities, due to lockdown fears and a lack of participants in short volatility trades. As the chart shows, the result in the second half of 2020 was a visible disconnect between price and volatility-based indicators.
At current levels, the RAI suggests we may not be far from peak market sentiment - but it stops short of telling us just how far. At least for now, we see benefit to remaining risk-on, and specifically long equities. That said, forward-looking returns from these RAI levels have historically been asymmetric to the downside, so it is prudent to be nimble and monitor the signal closely.
But sentiment is just one indicator; investors need to put it into context by considering fundamental and valuation factors, too. Cash allocations remain high among institutional investors, suggesting some caution in their positioning. And while average valuations appear quite high by historical standards, they appear less stretched in the context of record low bond yields. Meanwhile, Fidelity’s indicators of macro fundamentals as well as our bottom-up forecasts for earnings growth this year remain positive. So far as sentiment is a guide, it’s risk-on, and on.