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Warren Buffett remains one of the most famous investors out there, so it’s no coincidence that his sayings are equally famous.
One of my favourites has to do with two key emotions in the investment world: “Two super-contagious diseases, fear and greed, will forever occur in the investment community.
The timing of these epidemics will be unpredictable. ...
We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
The genial Albert Einstein said that compound interest is the eighth wonder of the world.
“He who understands it, earns it ... he who doesn't ... pays it.”
Now, I would never dare to disagree with a man of his calibre, but I would like to add that if compound interest is the eighth wonder of the world, then the herd-effect has to be the ninth.
The herd-effect is without a doubt one of the strongest forces out there, not only when it comes to consumer goods, but even stronger in the investment realm.
Let’s use bitcoin as an example. One year ago, the word bitcoin appeared in every second social media heading and it didn’t matter how hard I tried to explain to investors that it is incredibly difficult to calculate this cryptocurrency’s underlying value, at a then-exchange rate of $17 500/bitcoin, everyone wanted it.
Now, nearly a year later, and at $6 000/bitcoin, this crypto-blunder is hardly mentioned. Those who do, mostly refer to it as the worst thing that ever happened.
I even had to Google the latest bitcoin exchange rate, while a year ago, I could hardly miss it as it was posted on every lamppost.
And this is exactly where the herd-effect fits in so well with Buffett’s advice on being greedy when others fear. But can we measure this effect and express it as a figure?
With the help of historical data (which is no guarantee for future performance), I was able to find part of the answer in the Fear & Greed Index, made famous by CNN Money.
I’ve been following this index for quite some time and I have found that along with the fact that many short-term indicators use this index, it gives us a good indication of the emotional state of US markets.
I did some investigating on the mythology of this index and decided to apply/build it around the South African investment market as far as I possibly could.
The results were quite surprising.
In the South African version of the Fear & Greed Index, I used five indicators:
1. Market volatility
Here I simply looked at the South African Volatility Index (SAVI) and analysed how high (fear) or low (greed) it was trading above or below its 50-day moving average.
2. Running towards safety
This is one of the reasons why share prices go down when bond prices go up – the fact that so many investors choose to switch to the “safer” investment options in times of fear.
I used the FTSE/JSE All Share Index’s 20-day average returns and deducted it from the 20-day moving average of the SA All Bond Index (ALBI). When share prices start to drop and ALBI prices start to rise, it can indicate a sense of fear.
3. Share price strength
Having a look at how many companies make it to the JSE 52-week highs vs. how many make it to the 52-week lows also gives us a good indication of the levels of fear or greed that exist in the market.
To place this in context: there were two more shares per day on the JSE 52-week lows compared to the 52-week highs over the last 12 months. On 12 November 2018, this figure had risen to 10 shares (indicator of fear).
4. The JSE’s breathing
By using the McClellan Oscillator, we can build an index by subtracting the daily total amount of shares that showed a net share price increase from the total amount of shares that showed a net decrease.
If this net result is positive, the graph will move upwards and this will give us an indication of greed. On the flipside, if the net result is negative, the graph will move downwards and give us an indication of fear.
5. JSE momentum
Sometimes, just by looking at an ordinary moving average, we can spot a trend on the JSE.
I took the JSE’s price levels relative to its 125-day moving average. If it trades above its 125-day moving average, greed is on the rise, while if it moves below this moving average, fear is on the rise.
By combining these five indicators (in equal parts) and indexing them (0-100), we can create a “barometer”, which can measure greed and fear.
Levels between 0 and 20 indicate extreme fear levels, while levels between 80 and 100 indicate levels of extreme greed.
Graph 1: Fear & Greed Index applied to SA markets (sources: Schalk Louw, Thomson Reuters and PSG Wealth Old Oak)
As at the time of writing (13 November 2018), this index sits at 15 points, clearly indicating levels of extreme fear when it comes to our local stock market.
My question is this: should we join the herd and run away out of fear, or should we do as Buffett does, and become greedy when others fear? Only time will tell.
Schalk Louw is a portfolio manager at PSG Wealth.
