WHAT WE KEEP FORGETTING ABOUT MARKET EUPHORIA & GREED

I am sure you have seen various versions of this chart many times before.

What I can tell you about this chart is that it will always get you out too early and in too late!  What is missing is an understanding of how markets actually transition. Let me explain.

Warren Buffett is well known for describing the market as a "slot machine" in the short term, but a "weighing machine" in the longer term. In the Longer Term, Market Fundamentals matter but in the Short Term according to Buffett, it is nothing short of a "crap shoot" - "Spin the wheel take your chance!" -  All very 'catchie' but it does nothing to really help you time the market!

In our work we use a lightly different version of Buffett's idea:

  • In the Short Term the market reacts to SENTIMENT
  • In the Intermediate Term the market is influenced by RISK
  • In the Longer Term the market is controlled by FUNDAMENTALS
To some degree this is a little more helpful regarding what to look for and your market timing. Nevertheless, it is nice, but not terribly helpful regarding usability.
However, when we understand that Longer Term changes are initially signaled by a shift in Fundamentals (this doesn't mean the market reacts) which often goes unheralded and is typically ignored because of strong controlling sentiment. As Fundamentals continue to improve from bottoms, slowly Risk suggests that real risk adjusted returns merit stepping in. Eventually, Investors start to regain some confidence and the markets respond.
We must remember, at tops market Euphoria & Greed ignores poor Fundamentals, and then at bottoms markets ignores improving Fundamentals because of Pessimism and Fear. This doesn't tell us about timing but it tells us what is definitely ahead. Sentiment gives us an understanding about timing.
FUNDAMENTALS (Improve at Bottoms) > RISK (Improves) > SENTIMENT (Moves to Euphoria & Greed as Tops Are Found)
FUNDAMENTALS (Decline at Tops) > RISK (Worsens) > SENTIMENT (Eventually turns to Pessimism and Fear)
WHAT DO WE HAVE NOW?
 Few would argue we presently have:
  • Some of the Worst Fundamentals in the history of the Financial Markets,

  • Obscene Risk levels for which offer poor potential returns

This suggests that Longer Term FUNDAMENTALS and Intermediate term RISK have turned. When both have occurred this suggests we are in the later stages of a market top. This is important to recognize and to plan accordingly.

SO WHAT ABOUT SHORT TERM SENTIMENT?

The central problem with SENTIMENT is that it changes suddenly and for as of yet unknown reason! Former Federal Reserve Chairman Alan Greenspan specifically outlined this problem in one of his annual Humphrey-Hawkins testimonies before the US Congress. Sentiment & Confidence is like an avalanche, which with one gust of wind or a single now flake is suddenly triggered.

Stock prices run in cycles. Periods of re-pricing are usually quick and powerful.

Here is a way to consider the possibility of expected SENTIMENT shifts from a Longer Term perspective and to size just how large the avalanche just might be:
 
ONE MORE "SNOWFLAKE" MAY DO IT
Now lets consider how to interpret how SENTIMENT may soon react.   It is getting nervous as this work by Tyler Durden graphically suggests:

2.8% drop in stocks is all it takes...

...to convert sheer near full euphoria into outright panic...

Source: CNNMoney

Quite a collapse in confidence for a 'blip' in stocks... (NOTE - this collapse in sentiment is bigger and faster than the plunge in Aug 2015 following China's devaluation and the US flash crash)

 

At the same time, the 'plunge' in stocks has hammered BofAML's Global Panic-Euphoria index out of 'Euphoria'...

On a global basis, put-call ratios signal less euphoria than a month ago, and volatility has risen, taking Global Risk-love indicator from a protracted period in euphoria to barely inside the neutral zone.

With most of CNN's Fear & Greed factors suddenly flashing "Extreme Fear"...

 

But there's just one big caveat - almost 40% of the S&P 500 members are now trading below their 200-day moving-averages...

And that is what years of Central Bank conditioning does for investors' risk appetites.

You can be assured, Sentiment will soon abruptly change. Whether a few months or a couple of quarters - it will happen!

Make sure you are fully prepared. Remember, the top 5% and bottom 5% of market gains are always the most expensive.