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As Warren Buffett is 
famous for saying “…be fearful when others are greedy and greedy when others are fearful” and now is such a time. The crowd can be right for a long time, but they are rarely right at extremes and, while this time may be different, the probabilities suggest that at the very least it will be a more difficult environment for equities going forward.
The above are edited excerpts from an article* by Charlie Bilello, Director of Research (pensionpartners.com) entitled Fearful When Others Are Greedy.
The following article is presented by Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), www.FinancialArticleSummariesToday.com (A site for sore eyes and inquisitive minds) and the FREE Market Intelligence Report newsletter (sample here; register here) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.
Bilello goes on to say in further edited (as indicated) excerpts:
Investors are unequivocally greedy today, and with some perspective it is hard to blame them. After all, stocks are at all-time highs and the Federal Reserve continues to encourage risk taking with the most expansionary monetary policy in history. Risk has become a thing of the past as it feels like an eternity since we’ve experienced a real correction. Volatility is also near record lows, which further engenders confidence in the belief that buying equities here is a risk-free transaction.
Why is any of this a problem? Isn’t confidence a good thing which will only lead more and more people to buy in, aka the “greater fool”? It certainly can be – and most of the time sentiment data is just noise.
However, last week we moved past the noise level to an extreme in one of the longest running sentiment polls: Investors Intelligence. Last week’s poll showed 58.3% Bulls and only 17.3% Bears. The spread between Bulls and Bears of 41% is higher than 94% of historical readings and at a level from which further equity gains were much harder to come by.
Let’s have a look at the data.
As you can see by the tables below, the forward S&P 500 returns following a Bull-Bear spread of greater than 40% are significantly below average. The average 26-week (6-month) and 52-week (1-year) S&P returns following such extreme readings are only 1.2% and 1.6% respectively. This compares to average 6-month and 1-year returns of 4.0% and 8.3% in all time periods.
You’ll correctly note that while below average, these returns are still positive. This is true as the equity market has a strong upward bias over time and there are few indicators (not subject to data mining) that actually point to negative average forward returns. From my perspective, significantly below average is about as close as it gets to a negative reading. Also, being close to 0% average returns implies that nearly half of the forward returns are negative, which is actually the case.
What are the odds that what happens next will mirror the sharp declines following extreme readings seen in April 2011 and October 2007? Not very high, as sharp declines are indeed quite rare. Buffett instructs investors to be “fearful” when others are greedy, not to “sell short” when others are greedy as markets tend to rise over time and picking tops is an impossible task. Also, investors can remain greedy for long periods of time.
What we can say, though, is that the odds of below average returns going forward are certainly higher today than if we saw a more muted level of optimism among investors. We have seen this first hand in 2014 following the extreme sentiment readings witnessed at the end of last year. We’re now five months into the year and the average stock as reflected by the Russell 2000 (IWM) is down on the year, while defensive areas like Utilities (XLU) and long duration Treasuries (TLT) are up over 13%. Despite the constant barrage of headlines on “new all-time highs,” it has cost you nothing in 2014 to respect the sentiment extremes entering the year and act in a more “fearful” manner.
Conclusion
…You would be wise to start showing some level of fear here in the face of extreme greed by the crowd. The crowd can be right for a long time, but they are rarely right at extremes. While this time may be different, the probabilities suggest that at the very least it will be a more difficult environment for equities going forward.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://pensionpartners.com/blog/?p=336; © 2014 Pension Partners, LLC – All Rights Reserved. (This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.)
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