Fear as a Driver
of Future Returns
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?
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.
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.
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”.
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.
The chart gives a historical perspective of periods of greed and fear. Low readings indicate fear and high readings greed. Generally speaking, any period with a reading below 20 suggests a significant period of stress and a potential opportunity for the long-term patient investor to add excess cash.
The table below gives the walk forward total returns of the S&P 500 index from various fear entry points. Over the last 15 years, there have been 220 business days (5.8% of the time) where fear has been elevated and the Fear and Greed Index is below 20. May and October 2022 are the most recent periods. These periods can provide a decent entry point for the long-term investor.
S&P500 total returns over 12 & 24m, after periods of fear.
It can also be seen that at least over the last 15 years, the more extreme the reading, the greater the walk forward return. With a very rare sub 12.5 reading delivering on average a 52% return over the next 24 months.
Historical Periods of Extreme Fear.
The most extreme periods are highlighted on the above chart: the Global Financial Crisis (GFC) Oct 2008, Covid market lows, and the more recent Ukraine conflict coupled with the Fed’s rapid rate normalisation period, all experiencing a similar amount of extreme fear. If nothing else, it is useful to put 2022 into perspective as a rare event of extreme stress, and if history is a guide things will normalise and good times will emerge on the other side.
Depressingly, according to the last BOA March 23 Fund Managers’ Survey, the current most hated asset is US equities with around 45% underweight and the most loved is cash with around 40% overweight. It is clear that pessimism and fear is widespread, and investors are in full flight mode. If history is any guide, those who do the opposite, and switch out of cash into equity should do well. Should an even bigger event materialise, like the most anticipated recession in history, then over the very long-run a mean reversion to 6.7% after inflation should be the very respectable consolation prize.
If you have time on your side, ignore the perpetual bearish news and short-term fear, or better still, use it to add to equity exposure.
“The time of maximum pessimism is the best time to buy,
and the time of maximum optimism is the best time to sell” – John Templeton
By Mark Ellis, CEO Nutshell Asset Management
28th March 2023