The old saying of buy in gloom and sell in boom is much easier in theory than in practice, firstly because of the emotional aspect of investing and secondly the difficulty investors have in measuring the gloom.

One reliable measure of measure of gloom (and boom) is the equity risk premium.

The definition of equity risk premium is "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."

Below is an updated chart of equity market risk premiums for the Australian share market.  This chart highlights that equity market risk premiums are at levels not seen since the depth of despair from the GFC in March 2009 and in fact higher than they were during 1974 and 1980.  The way of interpreting this chart is the higher the risk premium, shares are cheaper, and the lower the risk premium, the more expensive they are.

You will also see that historically, following peaks in the equity risk premium there have been significant share market rallies such as that experienced during 2009 which saw the market rise by around 25%.

Much of the cause for pessimism relates to Europe and we remain of the view that a workable medium term plan for Europe can be found.  If this risk was reduced, one would expect equity risk premiums to drop which would result in an increase in share prices.  Arguably most if not all tail risk if already priced into the sharemarket.

Clearly we are not in boom times, which is why we have a bias to buy (selectively) not sell at this point.

Note: Advice contained in this articler is general in nature and does not consider your personal situation or needs. Please do not act on this advice until its appropriateness has been determined by a qualified adviser.  While the taxation implications of this strategy have been considered, we are not, nor do we purport to be registered tax agents. We strongly recommend you seek detailed tax advice from an appropriately qualified tax agent before proceeding.  The information provided is current as at March 2012.








Published in Investment Advice