Over the long-term, equity returns are very stable and persistent. We showed in a previous research piece “The Case for Long Run Equity Exposure” that any S&P500 25-year holding period in the last 100 years would have produced an annual return of typically between 10% and 16%. In log space it is very clear that returns are mean-reverting and persistent. Professor Jeremy Siegel shows that since 1802, real equity returns have been stable and remarkably consistent at 6.7% pa (over inflation). With this well-documented knowledge, why are so many long-term investors under-allocated to the stock market? And why do they often let “fight or flight” instincts dominate the short-term volatile holding periods with potentially catastrophic results?

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Most investors are unaware that they hold a winning lottery ticket in the form of time. A simple illustration is a 20-year-old putting a single year’s £20k ISA allowance into an investment product until retiring 45 years later at the age of 65. A “high risk” equity type product that manages to deliver 17% pa would yield an ISA worth some £23.4m, conversely aiming for a “safer” 4% would yield a pot worth just £117k. A stark demonstration that over the long-run the real risk is underinvestment.

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What is clear is that bad news sells and in stressed environments we have an inbuilt “fight or flight” instinct. In reality we should do neither, but rather calmly use any significant deviation from the long-run average return as an opportunity to invest excess cash, since it is very likely expected returns have increased and any drawdown will eventually mean revert.

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On 13 March 2020 we published an article titled “Volatility as a driver of future returns” and argued that there was a clear correlation between current volatility and expected returns over the next 12 and 24 months. History suggested that the S&P500 expected total returns had increased to 34.1% and 51.4% respectively over the next 12 and 24 months. Now, with hindsight, looking back at 2020 the realised return was significantly higher at 48.0% and 60.0% (this is consistent with the higher volatility of 83 as measured by the VIX index experienced in the week or so after publication). At this time global retail and institutional investors were hitting the sell button and liquidating at record levels and paying extreme levels of volatility for portfolio protection. Exactly the opposite of what history had shown was the rational thing to do. What was clear to us at the time was that long-term investors should have been adding to the market. Warren Buffett simplifies the strategy as to be “fearful when others are greedy and greedy when others are fearful”.

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With this in mind, and given the fact that the level of volatility has been relatively subdued (Positioning on expectations of a recession may be a reason) I thought I would dust off an old Fear and Greed Index I created several years ago. Like the CNN Fear and Greed Index, it uses a total of 10 equal weight factors that I have collected over the years as indicative of fearful markets. These include volatility, credit spreads, relative strength, equity risk premium etc. The chart below shows the last 15 years of daily data.