When Greed Isn’t Good: Impulses That Will Cost You

Eric Fry By Eric Fry
Macro Strategist

Market Trends

Greed isn’t always good. Sometimes it’s a very costly impulse. The present moment may be one of those times.

Greed seduces; it never promises. Sometimes its seductions deliver a satisfying result; other times, not so much. That’s why greed is such an unreliable investment partner… especially when greed’s guidance is pointing toward a “sure thing.”

The more an investment seems like a sure thing, the more likely it is to disappoint, if not utterly fail.

In the world of investing, we call greed “bullishness.” The opposite sentiments of caution and fear are called “bearishness.” Whenever either one of these sentiments reaches an extreme among the investing public, the stock market typically reverses course and heads in the opposite direction.

In other words, investors tend to become extremely bullish at major stock market peaks, just before a sell-off begins. And they become extremely bearish at major stock market bottoms, just before a new upswing begins.

These patterns have repeated themselves over and over again throughout the long history of financial market booms and busts.

At first blush, it may seem confusing and counterintuitive that extreme bullishness would precede a sell-off. But actually, this phenomenon is fairly straightforward.

When investors lack fear, they also lack caution… and when they lack caution, they take risks. The longer those risks pay off, the more invulnerable they feel.

The more invulnerable investors feel, the more complacent they become – until the stock market eventually reminds them that risk-taking hurts sometimes. That’s when investors rediscover fear, if not abject terror, as share prices fall.

Then the cycle from fear to greed to fear starts all over again.

Historically, widespread fear – i.e., bearishness – tends to present great buying opportunities, whereas widespread greed – i.e., bullishness – tends to present great selling opportunities.

That’s why many successful investors pay attention to investor sentiment gauges like this…

The CBOE Volatility Index (VIX), also known as the “fear gauge,” puts a hard number on the average level of fear among stock market investors. To arrive at this hard number, the VIX tracks the pricing of certain put and call options on the S&P 500 Index.

When a falling stock market causes volatility to increase, options prices rise, which causes the VIX to rise. Conversely, when the giddy pleasure of a rising stock market dampens volatility, options prices fall… as does the VIX.

Net-net: A high VIX reading indicates a high level of investor fear; a low reading indicates a low level of fear.

Extremely high VIX readings tend to coincide with market lows, whereas extreme low readings tend to coincide with important market peaks. The VIX does not possess a perfect record of signaling major market tops and bottoms, but the record is rather impressive.

The chart below presents a visual history of the VIX relative to major stock market highs and lows…

Source: Bloomberg

For example, the VIX spiked during the 2008 crash, thereby signaling a major market bottom… and a great buying opportunity. Conversely, the VIX plunged to an extreme low in late 1999 and early 2000, signaling a major market top.

But the VIX does sometimes flash warning signals that prove to be false alarms. Its signals are not 100% reliable. So it is best to think of the VIX readings as indications of relative risk rather than absolute “Buy” or “Sell” signals.

Extremely low readings on the VIX indicate that stocks are relatively risky and unlikely to deliver strong returns over the next year or two. Extremely high readings indicate that stocks are close to a major low and will likely deliver strong returns over the next year or two.

So where is the VIX today? It’s low… very low.

Two weeks ago, as the S&P 500 surged toward another new record high, the VIX fell close to the lowest reading of its 27-year history. It has bounced a bit since then, but it is still sitting close to all-time lows. These VIX readings are telling us that investors are very bullish and complacent.

The VIX could easily continue to fall, as the U.S. stock market continues to climb from record high to record high. For nine years running, U.S. stocks have been racking up winning numbers. Perhaps another nine years of gains await.

But for those investors who harbor some concerns that stocks might fall again one day – or who simply wish to hedge a portion of their portfolios – Wall Street provides a broad menu of VIX exchange-traded funds and exchange-traded notes. But be forewarned: Their investment results during the last few years have ranged from disastrous to catastrophic.

That’s what happens when you bet on falling share prices… and they go up instead.

But financial markets are cyclical creatures. They cycle through bull and bear markets; through episodes of greed and fear.

Today’s uber-complacent investors will rediscover fear at some point. In fact, if the VIX is to be trusted, fear may be returning soon to the U.S. stock market.

Good investing,

Eric