Posted by on May 8, 2014

Fear and Greed

There is an old Wall Street adage that I believe is attributed to Warren Buffett which goes something like … “to be successful in the markets you need to learn to be fearful when others are greedy and greedy only when others are fearful.”

Like so much of what the world’s greatest investor says, it seems to make so much sense looking back at markets with irrational exuberance, crowd mentality, momentum investing and price bubbles popping over the years. Warren Buffett has made some spectacular investment gains over the years, but he has not always been the best market timer. To him, it is not about market timing, of course—he has an objective to buy great businesses obtaining value rather than worrying about the price. Also to him the ideal holding period is forever.

However, is Warren’s fear and greed adage true for those of us who are not offered the deals which Mr. Buffett chooses from, and cannot hold their investments forever?

I did a very un-scientific study looking at monthly returns over the past couple of years to try to get my head around this.

To determine the crowd mentality of fear or greed I chose to use an emotional measurement from CNNMoney.

Fear & Greed Index looks at 7 indicators to try to measure the degree of fear or greed present in the market today. It shows a 31 on May 7, 2014. Like I said, this is a quick and dirty un-scientific look. If you want to learn about what indicators they use check out this page.

Using this measure, I wanted to snapshot how the market, defined by the monthly price performance of the S&P 500 cash index, performed against the beginning of that month reading in Fear/Greed Index.

I couldn’t find a historical look back of this index, but they do post a chart back to May 2011, which, thanks to Alex in our Business Intelligence Department, was able to give a rough approximation of the readings. (Did I mention that this would be very unscientific quick look?) Of course, the reading could—and does—change intra-month, and the changes in the sentiment may actually be more enlightening. Also bear in mind that over the period observed the market experienced a gain of roughly 40%.

Here is the chart:Unknown

Source: CNNMONEY

I estimated the reading at the beginning of the month and compared that sentiment to the actual result of that month in the market.

Screen Shot 2014-05-08 at 10.53.27 AM

The scale ranges from:
Extreme Greed  > 80
Greed                60-80
Neutral              40-60
Fear                  40-20
Extreme Fear    < 20

I had 35 total observations:Screen Shot 2014-05-08 at 10.48.13 AMRemember the market overall had almost a 40% rise over the period observed. The average monthly return was positive 1%. So the first observation is that the market was fearful 10 times vs. being some type of greedy 18 times in the past 3 years.

But what pops out to me isn’t that Warren’s adage is wrong. The bullish indicator was correct; 69% of the time pulling the overall success rate on the direction of the market to 61% of the time over the next month, but rather the market’s sentiment got it really wrong (over 3% move the opposite way) more than half the time. Also note that the quote attributed to Warren says to be greedy only when others are fearful. That certainly seems to have worked.

The market registered a Fear rating of 30 at the beginning of this month. What will the end result be for May? Yesterday’s trading looked pretty scary mid-day, but the actual close was 10 point gain in the index. I think this comes down to the following. Extreme market sentiments are wrong more often than they are right. It just goes to basic reason and supply and demand if everyone is one way bullish or bearish you want to be careful. Most important is to develop a trade plan and not to allow the current market sentiment to affect your discipline.

I will play with these numbers a bit more in a future blog.

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