Unexplained market volatility occurs because investors vacillate among three “F” words: fear, fantasy and fundamentals. At times, we’re scared to death; at times, we become irrationally exuberant; and at times, we actually invest in fundamentals.
More than 20 years ago, Robert J. Shiller of Yale University concluded that price volatility was far greater than could plausibly be explained by any rational view of the future. He showed that prices are considerably more volatile than corporate earnings changes and exceed changes to economic activity by a wider margin. See Market Volatility, MIT Press, Cambridge MA, 1989.
More recently, behavioral finance experts have explained that we’re too focused on recent events and too quick to discount important past events. We believe that what happened recently is likely to be the trend for what happens next, and we act on it. And thus, for a short while, it can be a self-fulfilling prophecy as fear leads to more fear and fantasy leads to more fantasy. Shiller asserts that popular models cause people to react incorrectly to economic data and contribute significantly to price movements bearing no relation to fundamentals.
I like to think of this phenomenon as a meter of investor sentiment. I call it the “F Meter.” See Figure 1. It shows our position on the fear, fundamental, fantasy scale.
Figure 1: The F Meter
Source: Rick Ferri
I put the meter at the fundamental stage today because that appears to be where people are. Investors have become less fearful, and as a result, market volatility has diminished.
Recent breaking news about the European debt crisis has not led to sharp sell-offs here in the U.S. The Federal Reserve’s announcement that it intends to keep interest rates low until 2014 has not led to fears of rising inflation. Even the price of gold, the ultimate global fear meter is showing signs of puttering out.
U.S. investors have moved from fear to fundamentals. People are becoming more positive about our prospects. Good economic news is being viewed positively, rather than being dismissed as a random event. Sustainable GDP growth is being weighed against slower growth in Europe. An increase in exports in the U.S. is being weighed against a decrease in exports in Japan. Better jobs numbers are being weighed against an increase in consumer borrowing. We’re looking at a glass half-full rather than half-empty.
Some people will argue that it’s time to become bearish because too many people are optimistic. They point to the AAII Investor Sentiment Survey for February 8, which measured more than 50 percent of individual investor bullish and only 20 percent bearish.
I would disagree that being bearish, simply because others are bullish, is a viable long-term strategy. There is a time element that’s often left out of the equation. The data shows a clear period between fear and fantasy when the general population gets it right. I think we’re in one of those times.
That being said, I don’t believe the market will move into fantasy-land anytime soon. Stocks are still below their long-term average of 16 times price-to-earnings. One could argue that with low interest rates the correct PE should be closer to 18 times earnings, but I’m not holding my breath.
The best way to play “F meter” is not by timing the market. It’s by having a set allocation to stocks and bonds based on your needs, and rebalancing back to that allocation when the markets become full of fear or fantasy. When people are fearful, stocks decline, and your portfolio will become light on stocks. That’s the time to buy. When people become exuberant, stocks rise, and you’re portfolio will become heavy in stocks. That’s the time to sell.
A set allocation to stocks and bonds that is rebalanced during periods of fear and fantasy works very well over fluctuating economic cycles and over a lifetime. Don’t worry about timing markets, just sit back and take advantage of its fears and fantasies.
