Combining Equity Market Stress and Sentiment Indications

Does combining widely used measures of equity market stress with news sentiment as interpreted by large language models such as ChatGPT support a robust risk-on/risk-off market timing strategy? In their April 2024 paper entitled “Stress Index Strategy Enhanced with Financial News Sentiment Analysis for the Equity Markets”, Baptiste Lefort, Eric Benhamou, Jean-Jacques Ohana, David Saltiel, Beatrice Guez and Thomas Jacquot test a risk-on/risk-off strategy for equity markets that combines:

• A conventional stress index (SI) signal derived from VIX, the TED spread, a credit default swap (CDS) index and volatilities of major equity, bond and commodity markets. They standardize each measure, aggregate measures by asset class, average results across asset classes and normalize the average to fall between 0 and 1.
• A ChatGPT 4 assessment of market sentiment from Bloomberg Daily Market Wraps over the past 10 days to determine whether it is above (risk-on) or below (risk-off) historical average.

They consider six strategies and apply them to the S&P 500 Index alone, the NASDAQ Index alone or an equal-weighted basket of S&P 500, NASDAQ, Nikkei, Euro Stoxx and Emerging Markets indexes:

1. Buy-and-Hold the index or basket of indexes (benchmark).
2. VIX: Risk-off when VIX is above its 80th percentile (about 26).
3. SI: Weight stocks according to the SI signal alone.
4. News: Hold stocks according to the Bloomberg Daily Market Wraps sentiment signal alone.
5. SI+News: Weight stocks according to the product of SI and News signals.
6. Dynamic SI+News: each month weight stocks using either the SI+News signal or the SI signal, whichever has the higher Sharpe ratio over the last 250 trading days.

For comparison, they retrospectively scale long-only benchmarks to have the same volatility as the best-performing active strategy. For all 18 strategy tests, they assume frictions of 0.02% on portfolio turnover. Using the specified SI inputs and daily stock index returns since January 2005, and Bloomberg Daily Market Wraps since 2010, all through December 2023, they find that:

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