April 2018

Bob Cunneen, Senior Economist and Portfolio Specialist, NAB Asset Management

“Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy only when others are fearful”

                                – Warren Buffett, 2004 annual letter to shareholders

What are fear and greed and what do they mean if you’re an investor?

Instinctively we know what fear and greed are. Imagine you are at a family dinner. Fear is the alarm that you will have to eat the meal even though it tastes like poison. Fear is the perception of danger. You ‘fear’ that your investment portfolio is giving such large losses that this will result in a permanent loss of wealth. Fear makes you want to get out of your investment.

Greed is the polar opposite. Greed is the endless scoops of gravy being delivered to your plate by high positive returns. Greed is where you are so consumed with your rising wealth that you go back for seconds. With greed, you are willing to increase the amount of risky assets in your portfolio in a ravenous desire for wealth.

Can we measure how much fear and greed are impacting share prices today?

Fear and greed are extreme emotions. Just like the emotions of happiness or sadness, there is no single precise calculation for measuring fear and greed.

However, we can try to capture investor sentiment. This looks at how investors act and feel about changes in the share market. This can go some way to measuring fear and greed.

Let’s look at three different measures which together form a ‘sentiment gauge’. These are confidence, concerns and conviction.

We will concentrate on US shares because this is the largest market in the world with the widest number of indicators. 

1. Confidence

There are a smorgasbord of US surveys which aim to measure confidence. These surveys include the American Association of Individual Investors as well as the Michigan and Yale University surveys. Typically investors are asked a series of questions on whether they are bullish and optimistic, or whether they are bearish and pessimistic.

These responses are scored over time to give a track record of their performance. There are two notable concerns with these surveys. Firstly, there may be a gap between the survey response and investors’ actual beliefs. An investor may wish to camouflage their beliefs. Secondly, these surveys can be noisy, swinging wildly between optimism and pessimism given impulsive whims or dramatic recent events. Hence there are doubts whether these surveys actually provide a helpful signal or just confusion.

This is shown in Chart 1 below which tracks confidence, using the Sentix investor survey, against the share market (S&P 500 Index). 

Chart 1: Investor confidence is tracking US share prices, and both are currently very high

                          US shares vs confidence

 

* Sentiment gauge based on VIX volatility, Household share holdings, Sentix investor survey, Margin Debt and Policy Uncertainty Index

Past performance is not a reliable indicator of future performance.

Source: Federal Reserve St Louis, February 2018.

So where are we now in early 2018 on the sentiment gauge?

America’s S&P 500 Index rose by 21% in 2017 (Chart 4, blue line) and Wall Street seems to be in the ”greedy” phase according to the red line, the sentiment gauge. Indeed the sentiment reading now exceeds the high greed levels of 2000 and 2007 when the US share market peaked.

When sentiment is this positive on US shares, this shows evidence of irrational greed in the market. Warren Buffet’s wise adage “to be fearful when others are greedy” is a warning sign for investors.   

1 ‘Expectations of returns and expected returns’, NBER working paper series, January 2013, p.2-3.  © 2013 by Robin Greenwood and Andrei Shleifer.

Source : NAB assetmanagement April 2018

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