I’m undertaking a 1000-day reinvention project, blogging here daily to track my progress. In Thursday Thinker, I share a smart idea or theory.
In Mastering the Market Cycle: Getting the Odds On Your Side, investment expert Howard Marks writes:
Widespread risk tolerance—or a high degree of investor comfort with risk—is the greatest harbinger of subsequent market declines.
Marks proposes that it is at the time that investors see the least risk that there is actually the most, because this is when they have become too complacent, and fail to demand enough compensation for taking on risk.
Marks and many other commentators have noted that the investor population as a whole swings from greed to fear in a regular, though unpredictable, cycle:
One of the most time-honored market adages says that “markets fluctuate between greed and fear. In other words, sometimes people feel positive and expect good things, and when that’s the case, they turn greedy and fixate on making money. Their greed causes them to compete to make investments, and their bidding causes markets to rise and assets to appreciate.
But at other times, they feel less good and their expectations turn negative. In that case, fear takes over. Rather than enthuse about making money, they worry about losing it. This causes them to shrink from buying—eliminating the upward impetus beneath asset prices—and perhaps to sell, pushing prices down. When they’re in “fear mode,” people’s emotions bring negative forces to bear on the markets.
Since a quick peak of fear last April after Liberation Day, we’ve seen the market become mostly greedy. Investors buy the dip in the S&P 500 and bid up tech stocks to incredible valuations. Bond yields for longer-duration bonds haven’t offered a very high term premium. Similarly, the spread between risky bonds and U.S. treasuries has remained pretty narrow.
But we are seeing signs that fear is increasing. For example, credit default swaps (essentially insurance against bond defaults) have recently increased in price, reaching a high not seen since Liberation Day. This may reflect both concern over private credit defaults as well as concern over a slowdown arising from the current Middle Eastern conflict.
In the stock market, the equity-only put-call ratio, an indicator of expectations of individual stock declines, has been rising. Only when it rolls over (reaches a maximum and then starts declining) does it become a bullish indicator, because fear has reached a peak.
However, even though risk appetite appears to be decreasing, as evidenced by credit default swap prices and the equity-only put-call ratio, investors’ cash allocations are at a four-year low:
It’s only the most sophisticated investors that know to use credit default swaps or equity puts to hedge against a potential downturn in markets.
Seems to me, greed is too high right now, and investors aren’t demanding enough compensation for the risk they’re taking on. We are still within 5% of a high on the S&P 500 index despite some churn underneath the surface. There might be much more selling to come in the near future, but maybe not today, with the main index futures showing green for the third day in a row.