Fear and Greed – Time To Get Cautious?
Markets are largely driven by human participants with human emotions. There are many attempts to measure human sentiment when it comes to stock markets. One of the best comes from CNN which has developed its Fear and Greed index. What makes the Fear and Greed index interesting is that it measures what investors are actually doing as opposed to most polls which measure how investors feel about the future and tend to be far less accurate.
The fear and greed index is a contrarian indicator. This means that when the index shows fear, most of the news has been bad, people are scared and have been or begin selling. By the time the index reaches extreme fear, most of the selling is typically over.
And the opposite is true on the upside. When the index is showing greed, the news is generally good. Buyers are happy and have been buying for a while. But when the index reaches extreme greed, there’s very little good news left to come and very few people who are still willing and able to buy.
Below is a chart of the Fear and Greed Index over the last 3 years.
The chart below plots the Fear and Greed index against the price of the S&P 500. Vertical lines show periods when the index reached 80 or higher. Of the six times this happened, 5 (shown as red lines) led to a short-term peak in stock prices. The 6th time (the pink line) was a false alarm. The pullbacks ranged from modest drops of 5% or so to the large 30% decline we experienced back in March. Of the declines, some occurred as the index was making a peak while some lagged by several months.
Last Friday, the index hit a high of 91, before pulling back slightly to its current level of 88. While this is by no means any guarantee of a drop in stock prices (imminent or otherwise), recent history suggests that caution may be merited in the short term.