In early 2021, investors were buying heavily into equities. The strongest stock market rally in over 20 years made everyone extremely bullish about the future. Especially high-risk assets experienced massive capital inflows.
Fast forward one year later and we’re experiencing the exact opposite. The upcoming monetary tightening cycle and horrendous war in Ukraine (let’s all hope for peace soon) is making investors fearful about the future.
Stocks are witnessing their sharpest sell-off since the 2020 COVID-19 crisis. Major indices like the S&P 500 (SPY) (-10.6%), Nasdaq 100 (QQQ) (-15.7%) and Russell 2000 (-18.3%) (IWM) are down significantly from their highs just a couple of months ago. Due to their weighting structure, these indices are actually an understatement of the real pain investors are witnessing. The average stock in the total market (Wilshire 5000) is down 28.32% from its peak and approximately 1/5 of all stocks is cut in halve or worse. That’s the real pain.
You probably know several investors who are dumping their shares and make their portfolio more defensive now that fear is creeping into the market. Perhaps you are even (considering) doing so yourself. That’s not illogical. Every single investor, including me, is feeling this urge due to emotional behavior.
However, this is in violation with Warren Buffett’s greatest advice ever to accumulate wealth in the market:
Be fearful when others are greedy, and greedy when others are fearful.
This is a legendary quote. However, it’s also an intangible one for most investors. How do we know when others are greedy/fearful? Where are we today in this spectrum? And what should you do with your portfolio when you need to become fearful/greedy?
I have good news for you: You will find the answer to these very important questions in this article. Take your time to read through it, because I believe it’s one of the most important topics for your wealth generation in the market.
The Better Version of The Fear & Greed Index: The IO Opportunities & Risks Index
You have probably heard about the CNN Fear & Greed Index before. Many investors use this index to quantify fear or greed in the markets. In the past, I did so as well and even wrote an article about it.
However, over time I started to acknowledge the flaws of the Fear & Greed index and stopped using it for these reasons:
- There’s no data available, only a one-year chart and the latest data of each factor included in the index.
- As a consequence, it’s impossible to measure how accurate this index has been to predict future market returns.
- There are much better individual fear & greed measures which can be included in the index. Bond markets are distorted due to central banks, the S&P 500 is overweighted toward a couple of big tech companies, etc. I’m also confused why they compare read-outs with levels over the past 52 weeks instead of longer-term data. If the past 52 weeks saw unusual market activity, is it really a good idea to use this data?
While my investment service Insider Opportunities focuses on individual stock selection, I felt the duty to make an improved version of the Fear & Greed Index for my beloved members.
After loads of work, the IO Opportunities & Risks Index was born. Note that I purposely changed “Fear” for “Opportunities” and “Greed” for “Risks” to reflect that you should not be fearful for fear and not be happy with greed.
The IO O&R Index is a weighted index of five individual factors which all accurately describe fear & greed in the markets:
- The AAII Bull-Bear Spread (1-month average)
- The margin debt (1-year change)
- The average first-day IPO return (2-month average)
- The insider buy/sell ratio (3-month average)
- The Russell 2000 RSI (14-weekly)
So why do I dare to call it the “better version” of the CNN Fear & Greed Index? It resolves all the flaws.
- I believe the included indicators are a way better representation of fear & greed. (I describe them later in this article).
- Four out of 5 indicators have long-term data since 1997, while the fifth one is based on data since 2004. We do not compare daily data with last year, but we compare it with data since 1997 (or 2004).
- Most importantly, the index has a proven track record of predicting stock market peaks and bottoms.
Let’s discuss this third bullet point further with historical data.
As you can observe in the chart below, the IO O&R Index has been an extremely accurate bottom predictor over the past decade. A read-out below 5 (extreme opportunity, indicated in green) has been a perfect buying indicator in 2011, 2016, 2019 and 2020. The indicator was early to call the bottom of the 2000-2003 and 2007-2009 bear markets, but here it was also followed by strong long-term returns.
In addition, the index has also been a good predictor for future corrections. A read-out above 95 (extreme risks, indicated in red) has been an accurate warning indicator for the downturns in 1998, 2000-2003, 2007-2009 and also for the recent correction. Note that here as well the index has been early in several cases.
A table which lays out the returns might be more valuable to use here. In the table below, you can observe the average forward return of the Russell 2000 during the days that the IO O&R Index has been trading in a certain range. Again, data goes back since 1997.
If you have trouble interpreting the table, let me help you out:
- The days that the IO O&R Index was trading below 5, i.e. we see extreme opportunities, were on average followed by a 1.20% monthly return, 2.46% three-month return, 8.58% six-month return, 28.30% one-year return and 64.8% 3-year return by the Russell 2000.
- The days that the IO O&R Index was trading above 95, i.e. we see extreme risks, were followed by a 1.49% monthly return, 0.62% 3-month return, -6.57% 6-month return, -4.94% 1-year return and -3.56% 3-year return by the Russell 2000.
- As clearly indicated by the colors, the higher you go in the IO O&R Index, the lower the expected forward returns, especially in the long-term.
In other words, the O&R Index is NOT very valuable in predicting short-term returns. No-one can accurately predict daily market movements.
However, the O&R Index is highly valuable to predict long-term returns. When our index is pointing at extreme opportunities (fear), it has historically been followed by very strong long-term returns. When our index is pointing at extreme risks (greed), it has historically been followed by negative long-term returns.
The IO Opportunities and Risks Index And Its Indicators During The 2022 Sell-off
The upcoming monetary tightening cycle caused by record-high inflation and the Russia-Ukraine war has caused the stock market to drop significantly.
As such, the IO O&R Index has come down drastically from its March 2021 highs of 98.8. Currently, the index is trading at 4.4, indicating that the recent fear in the markets has created extreme buying opportunities.
Below, I provide you an explanation of each individual indicator, so you can clearly understand why there is extreme fear in the markets.
1) AAII Bull-Bear Spread: -20.63%; Extreme Opportunity
Each Wednesday, the American Association of Individual Investors (“AAII”) publishes the AAII Investor Sentiment Survey. This survey includes data from American investors’ view on the markets: are they bearish, neutral or bullish about the future? The most valuable indicator is the so-called bull-bear spread which gives the percentage of bulls compared to bears. To smooth out extreme fluctuations, we include the 1-month average bull-bear spread in our index.
As you can observe below, the bull-bear spread fluctuates between -30% and 50% and mostly trades above zero.
In April 2021, the AAII bull-bear spread peaked at 30.4% (or a 93.4 ranking). In other words, there were 30% more bulls than bears, a strong warning sign that all investors became too greedy. Indeed, higher risks stocks have come down drastically since then.
Last week, the Bull-Bear spread dropped to -20.79% (or a 1.3 ranking). In other words, investor sentiment today is among the 1.3% weakest days since 1997. Also, the read-out on Wednesday February 23 saw the most bearish level (53.7% of investors are bearish) since 2013, even worse than during the COVID-19 crisis.
As you can observe below, a >30% read-out (red) has oftentimes been followed by a correction, while a <-10% read-out has been a good bottom predictor.
If history repeats, today’s -20.73% read-out is a highly bullish sign for future returns.
2) Margin debt YoY change: 1.96%; Neutral
Each month, Finra publishes margin debt data. This is the amount of debt which is borrowed by US investors at their brokers to be able to invest more money than they have available at hand.
Margin debt has increased significantly from $131 bln in 1997 to $830 bln today. It’s highly cyclical based on the sentiment of investors. If markets tend to only go up, they become greedy and take on margin. If markets crash, they are forced to sell off positions bought with margins, also called a margin call. We include the YoY change of margin debt in our index to calculate the fear (strong YoY decline) or greed (strong YoY increase) amongst investors.
Margin debt dipped to $479 bln in March 2020 and peaked at $936 bln in October 2021, a staggering $475 bln increase in only one and a half year. The strongest YoY increase, 71.62%, was recorded in March 2021. This extreme greediness was followed by a significant correction in risky assets.
Last month, we witnessed the strongest monthly margin debt decline on record as stocks tanked: Margin debt decreased from $910 bln to $829 bln. On an annual basis, margin debt is still 1.96% higher, which causes the “neutral” read-out. However, if the recent trend continues, this indicator will likely turn to “opportunity” as well.
As you can observe below, YoY margin debt increases of higher than 40% have historically been a good predictor of corrections. In contrast, YoY margin debt declines of >10% have been a good predictor for bottoms.
Today’s margin debt read-out is a neutral sign for future returns. However, this is likely to turn bullish if the recent trend continues.
3) First-day IPO return rolling 2-month avg: 2.61%; High Opportunity
In times of extreme market greediness, investors start bidding way more than the actual IPO price, which is the fair price of the company according to the experienced investment bank. The difference between what investors want to pay and the fair IPO price which was set, is called the first-day IPO return.
Average first-day IPO returns peaked at a staggering 77% in January 2021, levels which were only seen during the dot.com bubble. I warned about the risks this implies for high-risk assets in my article “2020 IPO Bubble Just Reached Dot Com Levels.”
Indeed, the Renaissance IPO EFT (IPO) is down 34.0% since the publishing date of this article and the discussed bubble IPOs in the article have seen horrendous returns with an average decline of 57.91%.
Today, there’s an extremely low demand for IPOs and the new listings face very weak first-day returns (2.61% 2-month average). This is a clear sign that investors are fearful to take risks in the market.
As you can observe below, IPO returns higher than 20% have oftentimes resulted in significant corrections. In contrast, periods with IPO returns below 0% have always been a good time to buy.
Today, IPO returns are indicating that there is high fear in the markets. As such, it is a bullish sign for future market returns.
4) Insider Buy/Sell Ratio 3-month avg: 0.55; Opportunity
Insiders know their company better than anyone else. They buy shares when they believe their shares are undervalued and sell when they believe they have become undervalued. Insider trading has been proven to forecast future returns effectively. That’s both true for individual stock returns, as also for market returns.
A lot of insider selling should be viewed as negative, while a lot of insider buying should be viewed as positive. To smooth out fluctuations, we include the two-month average of the insider buy/sell ratio in our index.
In 2021, valuations have increased to unsustainably high levels, which led to a lot of insider selling. The buy/sell ratio declined to 0.24 in May 2021. In other words, for each insider purchase, there were four insider sales. This was a bearish sign, which indeed was followed by a significant correction.
Over the past months, insider buying activity has slowly picked up as markets started to sell off. The 0.55 ratio today gives a 16.6 ranking. In other words, the insider buy/sell ratio points at fear in the markets, but not extreme fear yet like during the 2018 and 2022 crashes.
As you can observe below, a read-out above 0.6 has been a strong bottom predictor in the past, while a read-out below 0.25 has been a good top predictor.
Insider activity indicates that it is slowly getting time to become increasingly bullish, but it is not a 100% buy signal yet.
5) Weekly RSI Russell 2000: 34.13; Extreme Opportunity
Lastly, we also include the volatility of underlying indices in our index.
The weekly Relative Strength Index, or RSI, is an indicator which includes the number of positive/negative weekly returns and their magnitude over the past 14 weeks. It shows how oversold or overbought a particular index is. We use it for the Russell 2000.
At the beginning of 2021, we experienced a massive rally of the Russell 2000 in one straight line. This was clearly unsustainable and eventually got followed by weak returns.
Over the past weeks, the index crashed drastically, which led to a 34.13 read-out. This gives a 4.3 ranking, or points at extreme fear in the Russell 2000 index.
As you can observed below, extremely overbought (oversold) moments have been generally followed by strong corrections (recoveries).
Today, the RSI Index read-out is a very bullish sign for future returns.
How You Should Invest During The 2022 Correction And Beyond
I do believe successful stock picking is the No. 1 driver to accumulate wealth in the market. That’s what I allocate 95% of my time to at Insider Opportunities. However, I firmly believe that risk management based on market sentiment can impact returns drastically as well. That’s why I also constantly follow up the IO O&R Index for my members.
Risk management does not mean raising cash close to 100% when risks are increasing. It means slowly adjusting your portfolio holdings more defensively/aggressively based on market sentiment.
At Insider Opportunities, we positioned our portfolio defensively at the beginning of 2021 as the IO O&R Index reached “extreme risk” levels. We raised our cash position and focused on buying defensive value stocks while everyone else was buying hyped growth stocks. With gains on value stocks like HP Inc (HPQ) (+109%) and DLH Holdings (DLHC) (+108%), we were able to limit our losses tremendously.
As stocks started their downturn at the end of 2021, we remained skeptical given that the O&R Index was still not in “opportunity” territory. We cautiously added some higher risks holdings, but were aware that the dip might be followed by the dip dip and the dip dip dip. In particular, I warned about the continuation of a bubble collapse in overvalued growth stocks in my article “The Epic 2021 Bubble Already Collapsed, We Just Entered Phase 2.”
Thursday morning, on Feb. 24, we finally wrote an article for our members that it’s time to buy the dip aggressively. As bad as it is for humanity, the Ukraine situation should not have an impact on the stock market. Our IO O&R Index reached a low of 4.4, the most fearful level since the 2018 correction. A big buying sign.
Markets rallied by over 4% after our article. After this move, I would like to believe that I’m a perfect short term market predictor. I must admit that we were just lucky with the timing here. The IO O&R Index is a beautiful indicator to predict long-term returns, but has no value in the very short term.
Based on the IO O&R Index, we’re confident that long-term returns will be very strong from today’s levels. As such, we advise to put cash at work and position your portfolio aggressively. However, it’s very important to pick out the right investments given today’s unique economic environment. Here are some tips:
Avoid companies with a weak balance sheet and negative free cash flows. These companies rely on external funding, which will be limited in the upcoming “monetary tightening” phase. As such, some of these companies might go bankrupt. Avoid stocks like Fubo TV (FUBO), Peloton (PTON) and SmileDirectClub (SDC) at all costs. Focus on balance sheets and cash flows.
Avoid highly cyclical companies. Rising interest rates will likely affect the economy going forward. While economic conditions are still strong today, a recession becomes likely if rates will be raised too quickly. Companies which are highly susceptible to economic cycles might continue to struggle going forward. Focus on companies with pricing power.
Lastly, I’m not a fan of large caps (yet) at these levels. For example, I continue to expect weak long-term returns for stocks like Apple (AAPL) and Nvidia (NVDA) which are still trading at stretched valuations.
While there will definitely be some bargains in the large cap space, most bargains can be found in the small-cap space. While large caps are still trading at their highest P/E ratio since 2000, small caps are trading close to their lowest valuation ever at a 13.5x forward P/E. We expect this valuation gap to close significantly in the coming quarters.
In the coming months, I expect stocks to rise as sentiment turns to normalcy. Enjoy the gains, but don’t get too greedy during the run-up. When the market becomes greedy again, think back about this article.
Be fearful when others are greedy and greedy when others are fearful. Our IO Opportunities & Risks Index proves that this strategy pays off tremendously in the long term.
Greed was increasing in 2021 with the O&R Index hitting 98.8. In the past, extreme greed has mostly been followed by significant corrections. History repeated as the market turning sharply lower at the beginning of 2022.
Today, opportunities are arising as the O&R Index dipped to 4.4, indicating extreme fear in the markets. In the past, extreme fear has been followed by an average 3-year return of 64.80% for the Russell 2000.
If you’re targeting strong long-term returns, today is not the day to make your portfolio defensive. Today is the day to become an aggressive buyer. However, be aware that the coming weeks might remain volatile. Also, avoid weak balance sheets, cyclical companies and overvalued large caps.
While buying the dip dip dip, let’s all have our thoughts with people affected by the war in Ukraine and hope for a fast resolution.