Why the greed gauge is good

We ALL get carried away every now and then - it's human nature. When share investors get carried away it's said they're being driven by one of two basic, and base, human emotions: fear or greed.

Greed strikes when prices are rising and show no signs of slowing down. This can lead investors to pay too much for their shares, often just before a boom turns to a bust. Greed is sometimes also called "exuberance" - a more palatable term, because "exuberant" doesn't make you sound as "greedy".

"Irrational exuberance" is a term coined in 1996 by the then-chairman of the US Federal Reserve Alan Greenspan and later taken as the title of a book by economist and Yale University professor Robert Shiller. It's simply a less blunt term for investors who display idiotic greed.

To avoid making the worst mistakes that come from being greedy (or fearful), it helps to know whether a current share price is justified by the fundamental (or intrinsic) values of the assets backing those shares.

Gauging how exuberant or gloomy the market is, as a whole, might not dictate your investment strategy entirely, but it could affect the timing of implementation.

For example, if you think the sharemarket has run too far ahead of fundamental values, it might not affect a long-term strategy to invest in equities, but it could influence whether you think it's a good idea to put that strategy into effect right now.

Ron Bewley, head of quantitative research and investment strategy for CommSec, says investing when you know the market is overheated is a sure way to be disappointed in the short term.

Even though the conventional wisdom is that it's "time in, not timing" the market that dictates long-term returns, Bewley says that if you can time your buying to coincide with a period when prices are depressed you can earn yourself a "free kick", or at least avoid the pangs of disappointment that occur when the market dips right after you've invested.

As the chart shows, CommSec's analysis has found that every period of exuberance since April 2004 has shortly after been followed by a period of comparative gloom. Investors can capitalise on these swings. The key is to understand how and why the swings occur, and when they're likely to happen.

Bewley says CommSec is now quite confident that it can show when the sharemarket becomes over-exuberant. As a rule of thumb, he says, if exuberance hits the 4 per cent mark (positive or negative) it's a strong sign the market will soon reverse. Sometimes it continues to become more exuberant (or more gloomy) first, but 4 per cent seems to be the magic number.

Shiller raises his head again here. In 1981, he published a paper, "Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?" Shiller knew that rational investors work out what an asset's price should be by first working out the income (in the case of shares, the dividends) they expect to receive from the assets, adjusted to a present-day value, to take account of factors such as inflation.

But Shiller found that share prices move too often and by too much - five times to 13 times too much, he said - to be driven solely by income or dividend expectations, or even by new information about future dividends that investors might factor in to a share price from time to time.

Shiller wanted to know if the price of a share today really does reflect the long-term "best estimate" of future dividend payments, discounted back to the present. And he concluded it often does not, that there were factors other than just expectations of future dividends driving share prices - among them, fear and greed.

Every day, analysts release forecasts of how they believe share prices are likely to perform in the future, based on their examination of the companies' underlying businesses. Some analysts are better than others, but as a whole they're not too bad at making educated guesses about future income and therefore future share price movements. Even if none of them pick it exactly, the "consensus forecast" is often a pretty good indicator.

Bewley says CommSec bases its analysis of market exuberance on these consensus forecasts. But it's not just raw consensus forecast numbers that drive CommSec's calculation of exuberance, Bewley says.

"What we've done over the past three years is work out that our interpretations of consensus forecasts are very good," he says.

Bewley says CommSec takes forecasts of companies' dividends and earnings from some 600 analysts, and then performs "non-trivial" analysis of the numbers. From these individual stock analyses CommSec constructs consensus performance estimates for market sectors and for the market as a whole.

"It's not that we just add something up," Bewley says. "This is our intellectual property. One is how we turn dividend and earnings forecasts into meaningful fundamental returns, and then … what's called in academic literature the 'forecast origin' - where do you make the forecast from?

"But what we've got is a way of identifying where bubbles are."

Bewley says CommSec's calculations of market exuberance can't easily be used as a trading tool. For a start, it measures a broad market or a market sector, not individual stocks.

But also, the consensus forecasts CommSec uses are not for dividends and earnings in the next few days or weeks, so when its analysis says the market is excessively exuberant (or gloomy), it means today's prices don't properly reflect the likely longer-term performance of the market.

It assumes that once you've invested in equities you'll remain invested in equities for a considerable period of time, not for just a few days or weeks.

Nevertheless, Bewley says the analysis continues to prove its worth in helping investors time the execution of their equities strategies, most recently correctly identifying an "exuberance bubble" at the end of 2006 (exuberance hit 4.03 per cent), which corrected in the early days of 2007. Investors using the analysis could (and should) have avoided buying into the market until exuberance levels subsided.

At the close of trade on Wednesday exuberance was again moving towards 4 per cent, suggesting that investors might be well-served by holding off investing until the numbers move back closer to 1 per cent, or lower.

"But we're not suggesting this is a trading rule for investors," Bewley says. "What it's saying is, the way I would use it, is if you are 'refuelling' a portfolio … you'd do it at a point of low exuberance, because then you get a free kick.

"Say you want to invest, and you put all your money in in May [2006]. In the long run you're going to be fine, but you'd have felt very upset that you lost 10 per cent in the first months.

"So yes, this is a timing guide to help you enter the market, but not to trade.

"It's not a question of buying and selling on the highs and lows - that's too tricky - but it makes it so much easier in terms of your own emotions to start off with a bit of a win."