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Wednesday, 17 October 2012 00:27

Share market rallies usually follow pessimism - October 2012

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Is the glass half empty or half full? The pessimist would pick half empty, while the optimist  would choose half full.

Investors would be excused for failing to realise that share markets over the past 12 months have returned over 10%.  Investor sentiment is still negative as can be seen in the equity risk premium chart below.

Equity risk premium is defined as "The excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market. The size of the premium will vary as the risk in a particular stock, or in the stock market as a whole, changes; high-risk investments are compensated with a higher premium" (definition sourced from Investopedia)

Currently investors require a higher return from the share market due to risks, or perceived  risks, before they will commit money - which explains a high equity risk premium.  You will notice that the equity risk premium is at a level not seen since early 2009 during the peak of the GFC.  Once global policy makers took assertive action at that time, the share market rallied strongly.

What catches our eye is that share markets have performed strongly over the past 12 months despite enormous pessimism.  The ASX 200 for example at the time of writing is trading at 12 month highs and yet investor sentiment toward the share market is trading at multi decade lows as can be seen from the chart below which was sourced from Westpac Economics.

Historically, strong share market rallies have followed periods of extreme pessimism.

One of Warren Buffett's famous quotes is "be greedy when others are fearful". (and be fearful when others are greedy)

Those sitting on the sidelines must ask themselves "Is it different this time?"

This material has been provided for general information purposes and must not be construed as investment advice. This material has been prepared without taking into account the investment objectives, financial situation or particular needs of any particular person. Investors should consider obtaining professional investment advice tailored to their specific circumstances prior to making any investment decisions and should read the relevant Product Disclosure Statement.


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