The Greed/Fear Residual Strategy

A Quantitative Model for Timing Market Extremes, by Think_Reporter_8179

Raw data here

Overview

This strategy builds on the foundational work of economist Robert Shiller and his widely recognized Cyclically-Adjusted Price-to-Earnings ratio (CAPE) also known as Shiller PE. The Shiller PE smooths out earnings over a 10-year period to adjust for economic cycles, offering a more stable signal of market valuation than traditional P/E ratios.

Residual Concept:

While the Shiller PE is a powerful tool, it exhibits a general upward trend over time due to long-term economic growth, inflation, and shifts in market structure. To adjust for this and extract meaningful overvaluation signals, a linear regression was applied to the full historical Shiller PE dataset (1871–present). This regression line represents the expected value of the Shiller PE based on its historical trajectory. The “Greed/Fear” value is the deviation above and below this trend. (Figure1, bottom graph)

Variants

The 20/4 variant - This optimized strategy exits the market when the Greed/Fear Number exceeds 20 and re-enters when it drops below 4. It represents extremely rare euphoria and deep pessimism. Despite only triggering two exits historically, it consistently outperforms Buy & Hold from 1940 onward. CAGR since 1980 is 9.67% compared to 9.11% for Buy & Hold.

The 15/4 variant - This variant exits the market more frequently—whenever the Greed/Fear Number exceeds 15 and re-enters below 4. It also consistently outperforms Buy & Hold across the modern market era. CAGR since 1980 is 9.61%, with 7.73% since 1940, making it a strong alternative for more active positioning. (Figure 2, images 1 & 2)

While Buy & Hold remains robust, these Greed/Fear threshold strategies demonstrate that valuation-based sentiment timing can improve long-term returns. The 20/4 model is best for minimalist investors. The 15/4 model balances performance and responsiveness. Both outperform Buy & Hold from 1940 and 1980 onward.

Procedure

Let PE(t) be the Shiller PE at time t. Let L(t) = a + bt be the best-fit linear regression of PE(t) over time. I define the residual R(t) = PE(t) - L(t). This residual represents the deviation from the trend—a proxy for market sentiment.

Interpreting Residuals:

- When R(t) >> 0: the market is overvalued relative to trend (potential euphoria or bubble).

- When R(t) << 0: the market is undervalued (panic or capitulation).

- When R(t) ~ 0: the market is roughly in equilibrium with its long-term valuation.

Strategy

Using empirical analysis, I observed that high positive residuals (e.g., R > 15 or R > 20) often precede sharp market declines, typically within 3–6 months. I also found that low residuals (e.g., R < 4) correlate with market bottoms and recovery periods. The strategy is to:

1. Exit the market when R(t) > X (e.g., X = 15 or 20).
2. Re-enter the market when R(t) < Y (e.g., Y = 4).

Back testing and Results:

Across historical time frames beginning in 1900, 1940, 1970, 1980, and 1990, the 20/4 and 15/4 strategies consistently outperformed Buy & Hold. For example, from 1980 onward (Figure 2, image 3):

- Buy & Hold CAGR: 9.11%

- 20/4 Strategy CAGR: 9.67%

- 15/4 Strategy CAGR: 9.61%

- Great Depression modeling was done as well from 1900 - 1940 (Figure 3)

Why It Works:

The strategy is effective because it systematically avoids periods of extreme overvaluation while reinvesting during pessimistic lows. It does not require forecasting future earnings or macro conditions—only a valuation signal derived from historical behavior. The approach is both statistically grounded and operationally simple, requiring monitoring of a single residual metric derived from the Shiller PE.

Conclusion

This model represents a practical synthesis of valuation theory and behavioral finance. By using a regression-adjusted Shiller PE residual, I normalize for historical bias and extract actionable sentiment. The resulting strategy is robust, transparent, and repeatable—making it a compelling alternative to traditional Buy & Hold for long-term investors.

Figure 1:

Top graph is \"Greed/Fear\" residual of Shiller PE, including the \"15/4 Strategy\" delineations. Bottom graph is the Shiller PE historical data with its trend. The \"Greed/Fear\" value is derived from this.

Figure 2

Figure 3