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Risk Trends: Sentiment Holding Back S&P 500 and Dollar Breakouts

By , Chief Currency Strategist
19 October 2012 06:35 GMT

There are many terms applied to the ebb and flow of investment sentiment in the markets, but they all refer to the same thing: the equilibrium at which additional risk of loss is accepted for a projected level of return or yield. In other words, are investors more concerned that a market will quickly move against them (termed ‘risk’ and often measured via volatility) or are they focused on the possibility of high capital gains or yields (termed ‘return’)? At the extremes of this spectrum, we have panic and euphoria.

Below are some of the terms that will often be used to describe the balance and you should be aware of:

Terms that refer the balance of market sentiment itself:

  • Risk appetite trends
  • Risk trends
  • Risk-Reward
  • Investor sentiment
  • Sentiment trends
  • Confidence level
  • Speculative appetite

Terms that describe a market that is not concerned with riskbut is rather seeking yield:

  • Risk On
  • Rising risk appetite
  • Bullish sentiment

Terms that describe a market that is focused on the threat of volatility and not tempted by yield:

  • Risk Off
  • Risk aversion
  • Bearish Sentiment

Where are Risk Trends Now and Where are They Heading?

Measuring risk trends is the more difficult part. A market is a collective of many different opinions, forecasts and positions. We want to measure the bigger picture of the masses. When sentiment trends are exceptionally influential (when ‘risk on’ or ‘risk off’ are the dominant driver for price), we often see the theme span all asset classes (leading to remarkable correlations) and develop the foundation for lasting trends and permanently change volatility levels.

Though this is a very influential driver, it isn’t particularly easy to measure accurately. We often use the S&P 500 as a measure due its familiarity, its upside bias and place of stocks in the modern portfolio. However, there is an additional skew that has been imparted on this benchmark that causes it to deviate from a pure risk-reward influence: stimulus. A long-bias for the index can be useful – as its reversal can tell us fear is so great is it overwhelms hope for central bank support in the future – but only if there is a balanced benchmark. To give a more unadulterated measure of risk, I made the Risk-Reward Index which combines a basic gauge of return (aggregate 10-year government bond yields of the majors) and risk (the FX Volatility Index). The results can be seen below.

Risk_Trends_Sentiment_Holding_Back_SP_500_and_Dollar_Breakouts_body_Picture_5.png, Risk Trends: Sentiment Holding Back S&P 500 and Dollar Breakouts

Comparing the Risk-Reward Index, we see that sentiment has climbed since June, but its progress is far more restrained than that of the S&P 500. The Index has not event overtaken its May swing high (that set the peak for 2012). The difference is largely a reflection of the influence that the Fed’s stimulus programs have imbued on the market.

Risk_Trends_Sentiment_Holding_Back_SP_500_and_Dollar_Breakouts_body_Picture_6.png, Risk Trends: Sentiment Holding Back S&P 500 and Dollar Breakouts

See the Tension in the Components

There is more to learn when we look at the Index’s individual components. From the graph below we can that returns are extremely low (in fact, that July lull was a historical low). The only reason investors are willing to invest in these extremely low-yielding markets is because of the equally-extreme low in risk. The FX Volatility Index is rounding out a five-year low. To understand where the tension lies, consider what is working against higher yields: a slowdown in growth, diminished investment and stimulus itself. It is difficult to lift returns in these conditions. In contrast, volatility can surge forward any economic surprise that crosses the wires. Specifically, traders should be watching: the Eurozone crisis, US Fiscal Cliff, the end of stimulus regimes and the tipping point where there is not enough capital to support low volume / low yield rallies.

Risk_Trends_Sentiment_Holding_Back_SP_500_and_Dollar_Breakouts_body_Picture_7.png, Risk Trends: Sentiment Holding Back S&P 500 and Dollar Breakouts

Safe Havens

Below is another chart to consider. We have the Dow Jones FXCM Dollar Index and the Risk-Reward Index (flipped upside down). We measured risk appetite trends above against the S&P 500 and established the influence of stimulus. The greenback is often considered the market’s primary safe haven. People move to the currency when liquidity is at a premium, but its extreme low yield (which the Fed has vowed to keep near zero into 2015) diminishes its appeal when risk trends level out – thereby weakening its ability to measure risk trends from a ‘risk aversion’ perspective.

As we see the S&P 500 stall below 1425 and the Dollar Index struggle to break from its descending trend channel (seen below) we know where to look to see which (risk benchmark or safe haven) will break higher and which retreats. In future articles, we will cover the level of risk trends and the upcoming catalysts that can lead to significant changes as well as traders that are generated from the trends and deviations.

Risk_Trends_Sentiment_Holding_Back_SP_500_and_Dollar_Breakouts_body_Picture_8.png, Risk Trends: Sentiment Holding Back S&P 500 and Dollar Breakouts

--- Written by: John Kicklighter, Chief Strategist for DailyFX.com

To contact John, email jkicklighter@dailyfx.com. Follow me on twitter at http://www.twitter.com/JohnKicklighter

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19 October 2012 06:35 GMT