Fear And Greed With A Roll Of The Dice

Authored by MN Gordon via EconomicPrism.com,

Bear markets take time.  They also provide countless occasions to lose money.  With each bounce comes an opportunity for investors to buy higher so they can later sell lower.

Major U.S. stock market indexes hit what is likely an interim bottom in the fall of 2022.  Since then, they’ve bounced with incredible vitality.  The bounce has brought new confidence to investors at what may end up being the worst possible time.

Many smart people have misconstrued the bear market rally – a sucker’s rally – as the origins of a new bull market.  After January’s stellar performance to start the New Year, calls of a bull market have come far and wide.

Maybe these bull market calls are right.  Maybe the stock market’s selloff this week was merely a consolidation period.  And the major stock market indexes will soon charge past their all-time highs from over a year ago.  We’re not so sure.

Billionaire investor Jeremy Grantham, and co-founder of the Boston-based money manager GMO, recently provided a well-reasoned assessment of where the stock market, as measured by the S&P 500, is headed.  In his 2023 outlook letter, After a Timeout, Back to the Meat Grinder!, which was published on January 24, Grantham noted:

“While the most extreme froth has been wiped off the market, valuations are still nowhere near their long-term averages.  My calculations of trendline value of the S&P 500, adjusted upwards for trendline growth and for expected inflation, is about 3,200 by the end of 2023.  I believe it is likely (3 to 1) to reach that trend and spend at least some time below it this year or next.”

As of Thursday’s close, the S&P 500 was at about 4,012.  Thus, to hit 3,200, the S&P 500 would have to fall 20 percent.  What to make of it?

Reversion to the Mean

The S&P 500 may not be as insanely overvalued as it was 16-months ago.  But it is still radically overvalued by historical norms.  The Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio is currently at 29.14, which is well above its historical mean of 17.

Unless, something has changed, and the past averages no longer apply, the stock market, as measured by the S&P 500, still has a lot further to fall.  More than likely, the decline will be coupled with some sort of financial panic that spurs people to make a run for the exit.  In fact, as noted by Grantham, a 50 percent decline is well within the realm of possibility.

“Even the direst case of a 50 percent decline from here would leave us at just under 2,000 on the S&P, or about 37 percent cheap.  To put this in perspective, it would still be a far smaller percent deviation from trendline value than the overpricing we had at the end of 2021 of over 70 percent.  So you shouldn’t be tempted to think it absolutely cannot happen.”

Grantham, if you’re unfamiliar with his work, has accurately predicted several bubbles over his lengthy career.  He correctly predicted the Japanese Nikkei stock market bubble in the late 1980s, the dot com bubble in 2000, and the housing bubble in the mid-2000s.

Grantham’s philosophy is very pragmatic.  His focus is centered on a basic financial principle: ‘reversion to the mean.’

This is an observation that all asset classes and markets will revert to mean historical levels from highs and lows.  And by Grantham’s estimation the decline in 2022 was not nearly enough to bring the S&P 500’s valuations back in line with its historical average.

Think Again

The stock market freefall that took place on Tuesday [February 21], dropped the Dow Jones Industrial Average (DJIA), the S&P 500, and the NASDAQ by 2.06 percent, 2.00 percent, and 2.50 percent, respectively.  This may not be much in the grand scheme of things.  But it was a good reminder that there is still plenty of danger imbedded in today’s prices.

In addition, when you factor in rising treasury yields, and the newfound allure of holding bonds, stocks become especially dangerous.  A 12-month treasury note, for example, is yielding over 5 percent.  Will the S&P 500 increase by 5 percent over the next 12 months?

Certainly, it could.  It may even rise more.  But, based on Grantham’s analysis, it could also lose 20 percent – or even 50 percent.

At what point does the risk of stocks become outweighed by the reward of bonds?

That’s up to each individual to decide, given their time horizon and appetite for risk.  Nonetheless, for many people, accepting a 5 percent yield – which is still below the rate of consumer price inflation – beats rolling the dice for a potential 20 percent loss.

And as yields rise higher, in the face of an overvalued stock market, the reward of bonds becomes more enticing.  At some point, investors will transfer more and more of their portfolios from stocks to bonds.  This drain of capital from the stock market will pull the indexes down.

This is all a very natural occurrence.  The relationship between interest rates and stock market or other asset prices isn’t complicated.  Tight credit generally produces lower asset prices.  Loose credit generally produces higher asset prices.

After two decades of artificially low interest rates, courtesy of the Federal Reserve, a massive stock market bubble was inflated.  If you think the decline of the major stock market indexes that took place from roughly January 2022 to October 2022 is all that was needed to expunge the prior excesses, you should think again.

Here’s why…

Fear and Greed with a Roll of the Dice

Warren Buffett, in the 1986 Berkshire Hathaway shareholder letter, offered the following insight:

“[O]ccasional outbreaks of those two super-contagious diseases, fear and greed, will forever occur in the investment community.  The timing of these epidemics will be unpredictable.  And the market aberrations produced by them will be equally unpredictable, both as to duration and degree.  Therefore, we never try to anticipate the arrival or departure of either disease.  Our goal is more modest: we simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”

This remark is a classic contrarian view on stock markets and the, sometimes, wild price swings that are experienced.  The observation relates to market psychology.  Investors, as a group, are compelled by emotions of fear and greed.

Rising markets attract emotions of greed, as investors bid up prices in the hopes of even higher prices.  When the bubble inevitably pops and the market falls, fear takes over, and investors sell just as the market bottoms.  Buffett’s advice is to do the opposite of the herd.

This all sounds well and good.  But it is easier said than done.  Clearly, the U.S. stock market indexes were overtaken by greed in 2021.  Smart investors sold prior to the market’s peak and sat out the decline.

But did they buy back in at the stock market’s interim bottom in October 2022?  Some did.  However, others didn’t.  Moreover, how does an investor know when the stock market’s consumed by fear and when it’s consumed by greed?

For what it’s worth, and it may not be worth much, CNN Business provides a Fear & Greed Index.  The index compiles seven different indicators, including: market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand.

The index gives each indicator equal weighting in calculating a score from 0 to 100, with 100 representing maximum greediness and 0 signaling maximum fear.  Currently, the index is at 63, which is firmly in the greed range.

In summary, according to Grantham, the stock market has further to fall to revert to its historical mean.  The reward of treasuries is starting to outweigh the risk of stocks.  Buffett says you should be fearful when others are greedy.  The Fear & Greed Index is standing firmly in the greed range.

What to do?

You could always roll the dice, buy shares of Tesla, and hope for the best. 

You’d certainly be in good company.  As of last week, retail investors had poured $9.7 billion into Tesla so far this year.

But by our rough assessment, lightening up on equity positions and going fishing for a few months is the better option.

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