What Happens When Others Are Greedy?

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by: Charlie Bilello

The stock market may be the only market in the world where buyers run away from sales.

As prices fall, the news is bad, fear takes over, and investors are more inclined to sell than buy. As prices rise, the news is good, greed takes over, and investors are happy to buy. One of the more fascinating things about markets is how quickly these emotions can change.

One year ago, with the S&P 500 trading around 1,810, investors were exhibiting extreme fear.

Today, with the S&P 500 at 2,340, they are exhibiting extreme greed.

What changed? One important thing: prices rose over 30%. Right on cue, investors are loving stocks again.

Which brings me to the title of the post. We're all familiar with the Warren Buffett saying that one should be "fearful when others are greedy and greedy when others are fearful."

But what does being "fearful" actually mean? Buffett never defines it and few bother to ask. Does it mean you should short the market, go to cash, or hide under your bed, quivering in fear?

To answer that question, we need to examine the actual data. Going back to 1969, when the percentage of Bulls in the Investors Intelligence sentiment index has been this high (top 5% of all values), what tends to happen going forward?

In the table below, you can see that the forward returns are still positive, but below average.

The percentage of positive forward returns is also generally below average.

It is important to note that these are tendencies, averages. There are a number of instances where sentiment was extremely greedy and stocks actually did better than average over the next 1-5 years. There are also instances where sentiment was extremely greedy and stocks declined over the next 1-5 years.

These are the instances that pundits tend to focus on. You will hear the perma bears say "sentiment was this optimistic in October 2007 and stocks declined over 50% from there." Conversely, you will hear perma bulls say "sentiment was this optimistic in January 1985 and stocks went up over 30% in the next year."

Both lines, while factually correct, are cherry-picking individual data points to fit a narrative. Being "fearful" and expressing that fear by going to cash or shorting the market is not a strategy supported by the historical evidence. Neither is pointing to a positive outlier suggesting that extreme bullish sentiment is actually a good thing.

The best one can say when investors are extremely greedy (as they are today) is the following:

1) Expectations should be tempered. The returns going forward are more likely to be below average than above average.

2) Don't expect to make money shorting the market or timing the market in going to cash simply because investors are greedy. There is a higher probability of a decline going forward than other time periods, but the odds of such a decline are still below 50%.

3) Greed is less good than fear. As illustrated in the table below, when there are few Bulls to be found the returns going forward tend to exceed other time periods.

I realize these points are not necessarily "actionable" or "tradeable" but the truth in markets rarely is. As Ed Thorp said in a recent interview with Meb Faber: "on wall street you're busy estimating things that you can't know exactly."

We can't possibly know what the market will do here with investor greed at high levels; the best we can do is estimate. That estimation based on this sentiment data alone: a below average forward return with a less favorable risk/reward than a year ago when investors were fearful.

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