Does Irrational Fear Exist In Global Markets?

 |  Includes: DBA, INP, SPY, TUR
by: Todd Feldman

We ask whether there exists irrational fear in the global markets? Of course there are many concerns but has the market priced in rational or irrational fear?

Our behavioral measures suggest there does exist irrational fear. How do we figure this out. We have two types of measures that we use. One measure is a more short-sided measure that puts a large weight on the current environment. The other measure takes a longer-term view. The idea is that the measure that is short sided is irrational where as the longer term view is rational. The irrational part comes from the tendency to forecast the current environment into the future. For example, if the market is doing poorly then I predict there is going to be a market crash similar to that of 2008. Only the current environment and the feeling of losing money lends me to believe the world will end. Where as the longer term view takes more into account.

We calculated the spread between this short-term and long-term behavioral measure for the United States stock market going back to 1970. We sorted the spread from largest to smallest to locate the dates in US stock market history with the largest spreads. As of 9/25/2011 the spread is very large suggesting irrational fear.

In the table below are the dates with the highest spreads indicating the times where irrational fear was at is greatest in the US along with the six month and 12 month subsequent returns.

Table 1: S&P 500 Returns

Date Subsequent 6 month return Subsequent 12 month return
11/1/1987 2.82% 6.99%
10/29/1978 7.28% 6.58%
8/8/1971 14.53% 16.99%
11/5/1989 7.10% -7.48%
4/3/1994 6.18% 13.50%
5/18/1986 7.29% 21.22%
8/8/2004 13.19% 15.55%
Average 8.34% 10.48%
Click to enlarge

Results from Table 1 suggest that returns over the next six months are positive. They are not huge returns but no market crashes or financial crises. Over the next 12 months again we find positive returns except for 11/5/1989, since there was a recession toward the end of 1990. Of the seven periods listed above, which dates does our model mimic the most? It mimics 10/29/1978 the most. If this is the case we can expect a 7% rebound over the following year. Even so the US market was volatile in late 1979 and early 1980.

What should an investor do in this type of environment? We suggest not selling current positions. We do not see a global financial crisis similar to 2008. Therefore hold on US positions such as S&P 500 (NYSEARCA:SPY).

Even though we expect the market to rebound over the next 6 to 12 months the long-term outlook is low equity returns. In these cases with low interest rates there does not exist many investment vehicles. Select emerging markets may look to be winners such as iShares MSCI Turkey Investable Market Index ETF (NYSEARCA:TUR) and iPath MSCI India Index ETN (NYSEARCA:INP) as well as agriculture, PowerShares DB Agriculture ETF (NYSEARCA:DBA).

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.