The emotions of fear and greed may play as important a role in the behavior of stock prices as valuations, earnings, and economic indicators. That may be an exaggeration when it comes to the long term, but in the short term these two emotions are just as important as any other factors.
This post introduces one of the more widely referenced market sentiment indicators, CNNMoney’s Fear and Greed Index. We discuss the role fear and greed play in the psychology of the market, how this index is constructed, and how investors can use it.
- What are fear and greed?
- How do emotions affect the stock market?
- Other emotions that can affect market sentiment
- How to measure fear and greed to identify irrational markets?
- Understanding CNNMoney’s Fear and Greed Index
- Pros and Cons of CNNMoney’s Fear and Greed Index
- Alternative market sentiment indicators
- How can investors use fear and greed to their advantage?
- New approaches to measuring market sentiment
What are fear and greed?
For as long as stock market investing has existed, it has been clear that price movements are not always rational. Rather, emotion played a key role in the decision making of investors. Of all the emotions that can affect the prices of stocks and other assets, fear and greed are the most ubiquitous.
When greed dominates, investors are concerned with maximizing returns. This is when investor confidence is high, and headlines often reflect good news. This is also when the prices of riskier assets like small caps, emerging market stocks and junk bonds outperform defensive assets.
When fear dominates, investors are concerned with avoiding losses. Investor confidence is low, and headlines reflect bad news and predictions of another recession. This is when safe haven assets like US treasuries and gold often outperform other asset classes.
The result is that prices oscillate within broader trend channels and trading ranges. Most of the time, investor sentiment sits somewhere between extreme fear and extreme greed. When sentiment is neutral, prices are a reasonable reflection of the market’s perceptions of their value. However, when fear or greed dominate stocks are more likely to trade at irrational levels.
How do emotions affect the stock market?
If you look at the price chart of almost any stock market index, you are likely to notice that volatility is greatest at major highs and lows. Very often these highs and lows don’t correspond with major changes in the economy or corporate profits either. Increasing volatility is a sure sign that emotion, particularly fear, is playing a part in the decision-making process of traders. Fear is not only associated with downside – the fear of missing out (FOMO) can drive prices to irrationally high levels.
Rational decision making is more likely to occur when market sentiment is neutral or close to neutral. When emotions like fear and greed dominate, decision making is often motivated by those emotions. This is when behavioral biases are most prevalent. We covered these biases in detail in our behavioral finance post. It’s also worth remembering that fear peaks at market lows and greed peaks at market highs. In the last two decades, greed was probably highest at the peak of the Dotcom Bubble, while fear was greatest during the Global Financial Crisis.
Other emotions that can affect market sentiment
Fear and greed are emotions that tend to affect the entire market and its participants. The following emotions and mental states can also affect individual traders, and from time to time the entire market.
- Boredom can cause traders to micro-manage positions and open new positions that don’t fit their trading strategy. This often occurs when volume and volatility are extremely low.
- Excitement, elation, and euphoria typically occur when a trader’s positions are performing well or after a large profit has been taken. These mental states can cause excessive risk taking.
- Frustration often occurs when a trader is out of sync with the market and nothing they do seems to work. This can result in the trader abandoning their strategy.
- Hope is common amongst investors who do not want to accept the reality of a situation. They will simply ignore losses and hope for the situation to improve.
- Anxiety is common when position sizes are too big, or a trader feels they are not in control.
How to measure fear and greed to identify irrational markets?
Market sentiment itself cannot be measured. Even if you were to ask every investor about their outlook for the market, the answers would be subjective. So, any sentiment indicator is really a proxy for a direct measurement. Market sentiment can be measured indirectly by measuring its effects on markets. This approach is not perfect which is why you should always consider more than one indicator.
Some sentiment indicators measure volatility, while others look at the price action of safe haven assets and risky assets. Other indicators are ratios that compare occurrences associated with greed and those associated with fear. The new frontier for measuring sentiment is the analysis of news reports and social media commentary. Any text gathered from these sources can be analyzed using natural language processing (NLP) technologies.
Understanding CNNMoney’s Fear and Greed Index
CNN’s Fear and Greed index is a composite index made up of seven components. Each component, as well as the index, is always rated at one of the following five levels:
- Extreme Greed
- Extreme Fear
The index consists of the following seven indicators:
- Stock price momentum: Market momentum is measured by comparing the S&P 500 index level to the 125-day moving average of the index. If the index is below the moving average, fear is dominant. If the index is well above the average, greed is dominant.
- Stock price strength: This is defined as the ratio of stocks hitting 52-week highs to the those hitting new 52-week lows. A higher number of stocks hitting 52-week highs signifies more optimism, or greed. The converse applies to stocks hitting their 52-week lows and fear.
- Stock price breadth: Breadth is measured by comparing the number of advancing stocks to declining stocks each day. For the Fear and Greed index the McClellan Volume Summation Index of NYSE stocks is used.
- Put and call options: This ratio compares the trading volume of put options with that of call options. If trading activity is higher for put options, the implication is that fear is dominant. When trading in put options lag trading in call options, rising greed is implied.
- Market volatility: The well-known VIX index is used to signify volatility. An increase in volatility is associated with higher levels of fear.
- Junk bond demand: Rising demand for junk bonds indicates that investors are more concerned with yield than with risk. This implies that greed is dominant.
- Safe haven demand: When fear dominates, investors begin moving capital to safe haven assets. This is often known as a “risk off trade”. Rising demand for gold, US treasuries and other safe haven assets therefore indicates rising levels of fear.
Pros and Cons of CNNMoney’s Fear and Greed Index
The following are some of the advantages of sentiment indicators like the Fear and Greed index:
- Market sentiment indicators can be used to confirm traditional technical analysis, and vice versa. Sentiment indicators can also be used to confirm the timing of long-term investments based on fundamental analysis.
- Fear and greed are perhaps most useful when you are trying to spot the optimal time to enter or exit a position based on other forms of analysis.
- Sentiment indicators can alert you to the emotions that may be affecting your own decision making. They can help you avoid the temptation to follow the crowd when doing so may not be logical.
- CNN’s Fear and Greed index is not dependent on any single variable, but rather the readings are aggregated from seven components. This removes the effect of external factors that may affect one of the variables.
There are however several drawbacks to take note of:
- Market sentiment cannot be used in isolation. Extreme fear sometimes implies a short-term buying opportunity, while at other times it can mark the beginning of a bear market. The opposite applies to extreme levels of greed. These readings need to be considered within the context of other factors.
- The warning signs that point to major corrections and bear markets are likely to come from the economy, not from sentiment indicators.
- A market sentiment indicator will not predict a black swan event and may not predict other major market moving events. This is why no indicator is a replacement for a permanent portfolio hedging strategy and diversification through asset allocation.
Alternative market sentiment indicators
Besides the CNNMoney Fear and Greed indicator, there are other sentiment indicators to refer to. In fact, all seven of the indicators that make up the Fear and Greed index can be used as sentiment indicators on their own. In particular the VIX index itself is frequently used as a gauge for investor sentiment.
The USD index can sometimes be used as a sentiment index. This index tracks the strength of the USD against a trade weighted basket of other currencies. The USD often strengthens as sentiment deteriorates and vice versa. By measuring the currency against a basket of other currencies, any country specific movements are reduced.
Futures reports like the Commitment of Traders (COT) report published by the CFTC every Friday show speculative and commercial net long and short positions. This is particularly useful for markets like commodity markets where derivatives play a large role. The speculative positions give a good indication of sentiment amongst professional traders, while the commercial positions indicate the underlying supply and demand.
Some technical oscillators can be used as a crude way to measure sentiment. This is useful when measuring sentiment around a single instrument. In particular, a 2 or 5-period Relative Strength Index (RSI) can be useful to detect extreme overbought and oversold levels that indicate greed and fear. An hourly, daily, or weekly chart can be used to give the sentiment level context.
How can investors use fear and greed to their advantage?
There are two ways to use an indicator like the Fear and Greed index.
Market sentiment as a contra indicator
Firstly, extreme reading can be used as a contra indicator. An extreme reading shows that emotion is driving the market and that this may present an opportunity. Sentiment should always be one of a handful of tools used. The fear and greed index is most useful when viewed within the context of the overall market’s price trend and the market’s perception of value.
The primary, medium term and short-term market trends can be determined using a 10, 50 and 200-day moving average. When the index is above the moving average the trend is up and when it’s below the average the trend is down. So, if the price is above the 10 and 50-day moving average, but below the 200-day average, the short- and medium-term trends are up, while the long-term trend is down.
A range of stock valuation metrics will give you an idea of how the stock market and various sectors are valued. The investment community’s perception of valuations is probably more important than the actual valuation.
Market sentiment indicators are quite good market timing tools during established trends. A good opportunity for profit taking often occurs when the index reflects a high level of greed during a bull market. This is when you can take advantage of stock price strength to reduce the size of overweight positions. Conversely, a high level of fear during a bull market is often the best chance you will get to buy stocks.
Dollar cost averaging is a popular approach to ETF investing. You can use the Fear and Greed index to improve your timing by holding back on purchases until sentiment is negative.
Using market sentiment for confirmation
The other way to use market sentiment is by looking for a change from fear to greed or from greed to fear. A change in sentiment, or a persistent trend in the direction of sentiment can be used to confirm investment ideas.
This is particularly valuable after a major correction or a stock market crash. If the medium- or long-term trend has moved from up to down investors should wait for confirmation of a new low. This will reduce the risk of being exposed to further downside and value traps.
If you wait for a change in the short term trend that is accompanied by a shift from negative to positive sentiment, and rising volumes you can reduce the risk of buying into a dead cat bounce which is followed by further downside.
New approaches to measuring market sentiment
The use and measurement of market sentiment is continually evolving. In fact, market sentiment is one of the frontiers being explored by quantitative asset managers and hedge funds.
Until quite recently the inputs for any decision-making tools were limited to market prices, financial statements, and economic data. This is now changing as more data is collected by websites, social media platforms and connected devices. This the number of potential sources of sentiment data is continually growing.
In addition, advances in artificial intelligence and processing power allows these big data sources to be analyzed quickly and exhaustively. LEHNER INVESTMENTS Data Intelligence Fund is an example of how big data and artificial intelligence can be used to create and manage sentiment driven trading strategies.
Data and user driven content is collected from social media and financial news sites. AI is then used to find patterns, define, and implement trading strategies and manage risk. The advantage of such an approach is that sentiment indicators are updated in real time rather than on a daily or weekly basis.
Conclusion: Understanding fear & greed
Keeping an eye on the levels of fear and greed in the market adds another tool to any investor’s arsenal. Emotions play a big role in the market’s price discovery process and should be included in any decision-making process. However, just like any other tool, the Fear and Greed index should be used in conjunction with those other tools.