Greed & Fear

Any serious investor should aim at learning about human nature and what underpins our decision processes and actions. E-motions are what drive actions in the stock market. Behavioural patterns and cycles have been the subject of numerous books and studies. The work of Tversky and Kahneman is the bible. The books of Montier, Thaler and many others are their gospels.

The decision filters underpinning market participants‘ buy and sell orders are a complex blend of both rational utilitarian considerations, but more importantly emotions. The human brain is the computer that analyses the information and come out with a decision to act and send the electro-chemical signals that trigger a trade.

At the centre of our mainframe lies the brain of a lezard. This brain makes us react fast without thinking. The emotional input received by ths brain is then refined by the cortex that produces images and other interpretations, it is then analysed more slowly by the neocortex. The lezard inside my head is why I still jump scared at the sight of a spider even if I know rationally that I can crush it, or why I sell too early when I can let my profit run its course.  It is the home of our primal instincts and the on and off switches to two of the most powerful forces in market: greed and fear,

Greed and fear explains value anomalies, such that it is not surprising that value investors have been the most vocal about the importance of exploiting these emotional patterns instead of being used by them.

Sir John Templeton, one of my heroes, owns the best quotes on the enduring greed and fear patterns at play in the market.

“Bull market are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”. (Templeton).

“The time of maximum pessimism is the best time to buy, the time of greatest optimism, the best time to sell.“

„To buy when others are despondently selling and to sell when others are greedily buying requires the greatest fortitude and pays the greatest rewards“ (and echoed by Buffet’s famous “Be greedy when others are fearful and fearful when others are greedy”.

„The best prices are obtained when the sellers are desperately selling and ready to sell at any price. And the best exit prices are achieved when the market is bidding up“

In a few quotes, Templeton summarises an investment philosophy and how greed and fears act as critical pillars of a behavioural cycle that market observants and participants have witnessed for centuries.

Pessimism (Buy), Scepticism (Buy), Optimism (Hold), Euphoria is the basic cyclical roadmap of the value investor. It can be refined by more sophisticated sentiment indicators, but overall reveals a rather predictable human tendency for changing moods. In the rational economic world, cutting the prices of hamburgers drive the demand for hamburger and vice versa. In the stock market, falling prices raise the fear of losses and tend to feed on itself in a herd-like mode and vice versa.

Informed by their pigeons during the battle of Waterloo, the Rothschilds made their fortune by buying, „when there is blood on the street or at the sound of the cannon“ and selling „the sound of the trumpet“, epitomising one of the greatest counterintuitive market behaviour that „Bull markets climb a wall of worries, Bear markets advance on a slope of hopes“. I was able to experience first hand the power of greed and fear, by surfing the internet bubble by luck (had I known I would have put my Zergo – later known as Baltimore Technologies and Recognition shares I had bought on a tax free ISA account) and sell before the top realising my own greed and the madness of the crowd surrounding me. I was also able to repeat this feat by cashing in at top of the property/commodity bubble in 2007 simply by constently reminding me of Templeton quotes and looking back at my own greed and fear with a good dose of historic perspective as a form of sanity check.

The best buying opportunities are found in the midst of bear markets when everybody is in panic mode and the best short selling opportunities are found when everybody is bragging about their new wealth, when the restaurants are full and and taxi drivers are tipping their clients and neighbours or when cranes can be seen everywhere and the largest tower building on earth is announced.

The universal paradox of market sis that every crisis should be seen as an opportunity („where ther is ruin, there is hope for treasures“) and that every great boom is sowing the seeds of its own excesses and eventual demise.

Euphoric times are times to sell. Fuelled by hopes, magnified by leverage and denial of changes at work, bear markets start as a slow grind and then crash as a capitulation to a new reality. They often end during the final forced liquidation chapter.

Greed is infinite while fear is finite. For the short seller, the important lesson here is that one should never underestimate the risk appetite of the stock market investor nor forget to take profits on shorts when they have paid off.

It is almost impossible to call the top as irrational greed can be longer than one can stay solven, but as a rule it pays to take profits in euphoria, initiate short sells on slopes of  hope (de-rating phase), and add to these in the capitulation phases (downgrades), and cover and even accumulate  during the final stage is liquidation.

People are more risk averse in bad times than in good times. They prefer the certainty of low returns that more uncertain returns in the future. Buying risk in bad times and selling risk in good times is a good strategy. However as the VIX, the volatility index, shows„there is no comparison between fear and greed. Fear is instant, pervasive and intense. Fear hits. Greed is slower.“

This matters as the „bell curve“ shown in the chart above is distorted by the relative intensity and speed of greed and fear. Kahneman quantified the ratio. Perceived greed and fears varies according to people, but on average fear is probably 2,5x faster than greed, while its intensity is perceived more strongly (at least twice as strong as the pleasure of winning) according to Kahneman. This may explain why bear markets are typically two times faster than the preceding bull market and erase a third of the previous gains on average.

Optimism is a biological default state. Pessimism is a rational state. An optimist can see an opportunity in every calamity, while a pessimist would see in calamity in every opportunity.

I am a realist, but I have trained myself to be an optimist, as one needs guts and a bit of faith to buy when everybody is fearful and sell when everybody is greedy.

Even armed with Templeton’s mantra, it is still very easy to be victim of our own emotions and fall victim of the survival and herd instincts hardwired in our brain from the time our ancesters were busy doing monkey business in the savana. A contrario, experience has also taught me the hard way that there is much to fear of fear itself and that it does not not pay to play heroes in the face of a fearful or angry crowd. This is why the use of rational systematic rules (ie a clear quantification of expectations) in order to exploit the irrational excesses of the market is a good way to stay nimble in our risk management and trading rules, to avoid falling victim of our own greed and fear sirens.

The VIX is a volatility index. It does reflect the cost of options and therefore gives clues about the propensity of market participants to hedge their portfolios in bad times  and be less ready to pay for insurance when the good times roll. An inverse VIX curve is therefore an interesting greed and fear indicators.

The CNN Greed and Fear indicator available on their money channel is also a useful gauge based on numerous technical and spread factors. And the list goes on and would be too long for this humble post.

Yet, noting replace the guts and the trained eye to fully appreciate how greed and fear is percolating in the market and how these sentiments can take a life of their own. At the extremes, greed and fear are the overwhelming factors. When stories and price momentum are ignoring the numbers and any value consideration, when short sellers are forced to capitulate and even your cleaning lady is buying as the press predicts new highs, you know greed is in the driving seat. 

The opposite works too. When bad news is ignoring the numbers, when short sellers have moved up the ranks in the Forbes rich list and the press talking about the four horsemen of tha apocalypse, when your cleaning lady says she will never buy a stock in her entire life, as companies are laying off and banks shrinking their balance sheet and investors have overweight cash position, you know fear is in the air.

At these extremes, it is time leaving the crowd and take a contrarian stance. In between, rising greed or rising fear will define the general trend and should be used in a trend following manner with clearly identified accelerating/decelerating momentum pivots. The next post should cover when it is time to be a contrarian buyer, a momentum buyer or a contarian/momentum seller.