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You're not Warren Buffett: Why investors should watch out for fear and greed in the market

Martin Pelletier: Warren Buffett doesn’t appear too worried about the U.S. economy or the equity market, which for many can be rather reassuring. But it’s important to realize that most investors lack the capital and the patience afforded to Mr. Buffett

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Berkshire Hathaway held its annual meeting this past weekend and Warren Buffett doesn’t appear too worried about the U.S. economy or the equity market, which for many can be rather reassuring.

That said, it’s important to realize that most investors lack the capital and the patience afforded to Mr. Buffett.

Therefore, in times like these it can be helpful to ask whether investors are being greedy, fearful or neither in the current market environment. In our opinion, we happen to be seeing little fear and a lot of greed.

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This is likely due to the U.S. Federal Reserve remaining intent on replacing the wealth effect lost from the housing market by inflating the stock market. The Fed through its quantitative-easing efforts has more than quadrupled its balance sheet to over US$4.2-trillion.

Investors have now become overreliant on the Fed continuing to jump in to prevent market corrections, at least until the broader economy has fully recovered. The problem with that belief is that it skews the overall risk/reward balance in the market by encouraging excessive risk taking.

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Consequently, investors who for the most part missed out on one of the most pronounced market recoveries in history are now using their low-interest margin accounts as a means to play catch-up or, worse, take out second mortgages to buy stocks.

Specifically, margin-debt levels reached an all-time high in March at US$466-billion, surpassing both the 2000 and 2007 highs. It’s amazing just how quickly many have forgotten the pain of undergoing a margin call.

Investors have also been chasing yield regardless of the underlying risk. For example, the market for leveraged loans — which are floating-rate loans issued to non-investment-grade companies and are considered to have a higher default risk — rocketed to a record US$605-billion last year, surpassing the pre-financial crisis high of US$535-billion reached in 2007.

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All of this risk taking is reflected in investor complacency, with the CBOE Volatility Index hitting record low levels. Interestingly, the spread between the S&P 500 and the VIX has blown out to record high levels, surpassing pre-financial crisis levels.

From a valuation perspective, the U.S. equity market appears to have disconnected from the broader economy. This is not unusual though, as there are periods when the two become out of synch, such as when the market was oversold in 2009 at only 62% of GDP and when markets reached a whopping 154% of GDP during the 2000 tech bubble.

Today, we’re at 125% of GDP, surpassing the 2007 high of 116%, but still below the all-time high in 2000.

In conclusion, until the Fed completely exits the markets, expect more greed and less fear, which is good news for investors for now. That said, it’s beneficial to undertake some form of risk management as the cost of doing so has become diminished with the high levels of greed in the market.

Martin Pelletier, CFA, is a portfolio manager at Calgary-based TriVest Wealth Counsel Ltd.

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