Fear and Greed Index
- Peter Lee
- Aug 19, 2020
- 3 min read
According to academics and professionals, human beings are emotional creatures. Human traits such as fear and greed are powerful motives that tend to influence us to buy and sell stocks often at the expense of common sense and self-control. Since traders and investors are emotional and reactionary by better understanding market sentiments we will become a better investor and trader.
History has shown that fear and greed can be reliable to help gauge pivotal turning points in the stock market. Market pundits also generally agreed that fear and greed indicators can be a useful tool to assist with investment and trading decisions.
There are currently many fear and greed indexes available to investors. The objective is to measure two primary emotions namely fear and greed to help gauge how much investors are willing to pay for stocks. In theory, it is a contrarian indicator based on the logic that extreme fear can drive stocks far below their intrinsic values creating buying opportunities. Conversely, widespread greed can bid stocks far above its intrinsic values leading to selling conditions.
There are many technical factors/indicators that go into creating a reliable fear and greed index. Enclosed are some of the more popular factors/indicators:
1. Speculative and high-risk assets - Junk bonds are often used to help evaluate speculation in the market place. Two widely followed High Yield/Junk Bond securities are iShares High Yield Corporate Bond ETF (HYG) and SPDR High Yield Bond ETF (JNK). Current interpretation – Extreme Greed as both ETFs have rebounded from their respective Mar 2-2020 lows and are now challenging their Feb 2020 all-time highs.
2. Options Activity - Options positioning can be a good proxy for market sentiments. The number of call and put options trading in the marketplace offer insights into the sentiments of traders and investors. Put/Call Ratio tends to be a popular options indicator that quantifies the number of puts and calls in the marketplace. Current interpretation – Extreme Greed as there are a lack of puts and many more calls currently circulating in the marketplace.
3. Market Breadth – Expanding or contracting market breadth often depicts whether the rally is broad-based (bullish) or narrow-based (bearish). Advancing issues minus declining issues is often used to evaluate market internals. Current interpretation – Moving into the Greed level as the advance/decline line for key indexes such as NYSE, SPX, and COMPQ have been rising strongly from the Mar 2020 bottoms. However, they are not yet trading at extreme highs.
4. Price Momentum – This is an important technical indicator that quantifies the speed, sustainability, and the magnitude of the current price trend. Popular price momentum indicators include Rate of Change (ROC) indicator and Distance from the 50-day or 200-day moving average (DMA). Current interpretation – Also, moving toward Greed level based on the sharp rally from Mar 2020 bottom.
5. Stock Price Strength – This is a relative measure that often denotes the number of stocks setting net new 52-week highs and 52-week lows on a broad market index. Current interpretation – Greed level as evidenced by the number of stocks recording 52-week highs as compared to stocks setting 52-week lows.
6. Market Implied Volatility – Typically is a gauge of market sentiments. The most common gauge for fear in the marketplace is the SPX Volatility Index (VIX). Current interpretation – Neutral reading as VIX is neither trading at a historical high or a historical low.
7. Defensive/Safe Haven Market Gauge – Assets that are considered defensive and safe haven can offer insights into the psyches of investors. US Treasury bonds (i.e., TNX or the 10-year US Treasury yield) are often deployed to evaluate risk-taking or risk aversion. Current interpretation – Trading at Neutral levels but the outcome of the 5-month head/shoulders patterns in the TNX and TYX will help to decide the next major trend.
Enclosed below are the charts of the 7 technical factors/indicators that make up the Fear and Greed Index.
What about cash levels as a sentiment indicator?