Weekly outlook

When to be fearful, when to be greedy

By Tom Stevenson, 11 March 2009

Learn to profit from the investment roller-coaster

It is a commonplace in investment that markets are driven by fear and greed. When markets have been rising for some time, investors hope and believe that they will continue to do so. In a bull market, even the nicest of us become just the tiniest bit avaricious. But when markets are heading the other way, anxiety takes over and our thoughts turn to protecting what we have. Our decisions are fuelled by fear. Over the past two years, investors have moved from great optimism to extreme pessimism as markets have suffered one of the deepest, and certainly one of the most rapid, bear markets. It has been a painful transition but by no means an unusual one and one which equity investors have to accept as the price they pay for the long-term out-performance of shares over less volatile investments.

"The fact that shares are cheap does not mean the bear market is over" Tom Stevenson

Such is the regularity of the swing between these two emotions that it is often presented as in the chart below:

 

Source: Westcore Funds / Denver Investment Advisors LLC, 1998, FIL

The emotions highlighted at various points along this roller-coaster will be familiar to anyone who has watched the value of their investments rise and fall over the years. Those who were investing in the late 1990s will certainly recognise the excitement, thrill and euphoria that prevailed during the latter stages of the dot.com bubble. As the speech-bubble indicates, investing in a steeply rising market really does feel fantastic.

The emotions at the bottom of the curve are closer to home today. Since last summer, investors have found themselves on the downward slope between fear and depression. And the journey is not always in one direction. You can pass through panic to despondency only to experience fear and desperation again if the market suddenly lurches lower as it has in recent weeks.

In little more than two months since the beginning of the year, the FTSE 100 has fallen by 20%, the traditional measure of a full-fledged bear market. As the UK’s benchmark index briefly fell below 3,500 this week, it captured all of fear, desperation, panic, capitulation and despondency.

The road to revulsion

A word which does not appear on this chart but which is commonly used at the very lowest point of the cycle is “revulsion”. It is the feeling, widespread at the bottom of a bear market, that you no longer want anything to do with the stock market. At this point, there is little coverage of markets in the media because prices are at rock bottom and no-one can see any good reason why they should not stay that way.

Moments like this in the past have typically been associated with extremely low valuations, prices for shares which, at the top of the market, would have seemed unimaginably cheap. For example, in the depths of the Great Depression a typical share was valued at just five times its average earnings over the previous ten years.

The average over the past 130 years or so, according to analysts at Societe Generale, has been about 18 times while at the peak of the equity boom in 2000 the equivalent multiple was close to 50. Today, Societe Generale calculates, UK shares are valued at around 10 times the past decade’s average earnings, which is not in Great Depression territory but is close to other periods of investor “revulsion”.

The fact that shares are as cheap as they have been in the past when the market began to recover does not mean that the bear market is over. What happened between 1929 and 1932 showed that cheap shares can become very cheap before greed starts to overcome fear again.

But for anyone buying shares with a long time horizon, the opportunities to find exceptionally cheap shares have not been so plentiful in years. And for regular savers and investors, today’s market levels are allowing them to buy more stock for their money than for many a year.

As Warren Buffett famously advised, investors should be fearful when others are greedy and greedy when others are fearful. But as anyone hesitating about whether to get back into the market, or to continue saving as the market hits new lows, will know, his advice is easier said than followed.