This indicator says the market is topping out again

Greg Canavan

Fat Tail Investment Research

If you don’t know who you are, this is an expensive place to find out.’

                                                                                                        The Money Game

This is one of my favourite quotes from one of my favourite books.

And it’s particularly important to keep in mind right now.

So is this one from the same book…

You can have no preconceived ideas. There are fundamentals in the market place, but the unexplored area is the emotional area. All the charts and breadth indicators and technical palaver are the statistician’s attempts to describe an emotional state.

It is my view that in the long run, the fundamentals (earnings, valuations, etc.) drive stock prices, but in the short run, it’s all about emotion and sentiment.

In a moment, I’ll show you a chart that explains this point clearly. It’s important to understand this psychological aspect of the market. It’s been around forever and will always be around.

That’s why recognising it and understanding your susceptibility to it is so important. Because if you don’t know who you are, the stock market is an expensive place to find out.

To explain, let me quote from a book I wrote a few years ago…

None other than Lord Keynes, who is better known for giving the world Keynesian economics than for his observations on market psychology, recognised the effect of mass psychology on market prices early on in the piece.

Keynes invested money for Cambridge’s King’s College, and considered himself a value investor. But he was also an acute observer of human behaviour. He understood how the market really worked.

In 1936, in The General Theory of Employment, Interest and Money, he wrote that professional investors and speculators were really no different from the “ignorant individual left to himself”. That is, they were all just trying to work out what everyone else thought, and trying to get ahead of each other, rather than assessing the “fundamentals”.

“For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, [our stock market closed model] but with what the market will value it at, under the influence of mass psychology, three months or a year hence. Moreover, this behaviour is not the outcome of a wrong-headed propensity. For it is not sensible to pay 25 for an investment of which you believe the prospective yield to justify a value of 30, if you also believe that the market will value it at 20 three months hence.

“Thus the professional investor is forced to concern himself with the anticipation of impending changes, in the news or in the atmosphere, of the kind by which experience shows that the mass psychology of the market is most influenced. The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelope our future. The actual, private object of the most skilled investment today is to ‘beat the gun’, as the Americans so well express it, to outwit the crowd, and to pass the bad, or depreciating half-crown to the other fellow.

“This battle of wits to anticipate the basis of conventional valuation a few months hence, rather than the prospective yield of an investment over the long term of years, does not even require gulls amongst the public to feed the maws of the professional; it can be played by the professionals amongst themselves. Nor is it necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity. For it is, so to speak, a game of Snap, of Old Maid, of Musical Chairs — a pastime in which he is victor who says Snap neither too soon nor too late, who passes the Old Maid to his neighbour before the game is over, who secures a chair for himself when the music stops. These games can be played with zest and enjoyment, though all the players know that it is the Old Maid which is circulating, or that when the music stops some of the players will find themselves unseated.”

That, ladies and gentlemen, is one of the best descriptions of the stock market game that you will ever read. You can have your “intrinsic value”. But the reality is that not one person in a hundred, or probably a thousand, or ten thousand, gives a hoot about intrinsic value, or even knows what it really means.

In the game of investing, it isn’t “necessary that anyone should keep his simple faith in the conventional basis of valuation having any genuine long-term validity.”

That’s because there are very few long-term investors, despite claims to the contrary. There are only millions of players passing shares to each other, hoping to get their hands on the ones that are going up, and trying to offload the ones that are going down.

This is the market. It’s mass psychology, underpinned by “fundamentals” that direct and determine the intensity of that psychology. It’s as true today as it was in 1936 when Keynes wrote about it. And it will be true in 100 years hence.

A game of Old Maid

Now, let’s bring this back to today’s market. Everyone is playing Old Maid, trying to front-run the Fed’s ‘pivot’ on interest rates. The market is taking a move from 75-basis-point hikes to 50-basis points as the first step in a pivot to lower rates.

It’s jumping the gun massively, in my humble opinion. Or, in the words of Keynes, it’s investors simply trying to pass the ‘Old Maid to his neighbour.’

With that in mind, consider the chart below. I looked at the CNN Fear and Greed Index and applied the peaks and troughs in sentiment this year with the moves in the S& P500.

Firstly, here are the movements in the Fear and Greed index over the course of 2022. A reading above 75 is extreme greed, while a reading below 25 is extreme fear.

At no point in 2022 has the index been in an extreme greed reading. But it has spent a decent part of the year in extreme fear. That’s a characteristic of a bear market.
CNN Fear and Greed Index


In the chart below, I’ve labelled the peaks in greed on the S&P 500, along with the period of extreme fear and fear:


Source: Optuma

Despite the ups and downs, as you can see, the overall trend is down. That points to deteriorating fundamentals, which is not surprising given the sharp rise in interest rates this year.

Now, for the first time this year, the index just hit an extreme greed phase. It recently hit a reading of 75 points, above the August peak of 68 points. This tells me we could be close to another bear market rally peak. 

Investors are playing the ‘Santa rally’ theme and expecting the good times to last into the new year. But the market is a master at catching the majority offside.

From a fundamental perspective, the Fed is still raising rates. The yield curve is the most inverted it’s been since the early 1980s, which is a strong signal of a coming recession.

Yet consensus estimates for 2023 have S&P 500 earnings growing 3.8%, putting the S&P 500 on a price-to-earnings ratio of 17.7 times!

If a recession does unfold next year, the market is completely wrong.

I’m not suggesting stocks in the US and Australia will collapse from here. I’m just saying probability suggests the bear market isn’t over.

Don’t get stuck with the Old Maid…

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Greg Canavan
Editorial Director
Fat Tail Investment Research

Fat Tail is Australia’s largest independent financial publisher. Greg is Editor of its flagship newsletter, The Fat Tail Investment Advisory, where he writes market commentary and looks for out-of-favour ASX 200 stocks on the cusp of a...

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