Many different market sentiment indicators have been developed over time to gauge bullish and bearish sentiment accurately.
However, one indicator, the so-called 'Fear & Greed' indicator, is consistently quoted by social media influencers and investment media when market sentiment is questioned.
We will shed some light on this indicator and conclude whether it is an accurate tool for measuring bullish and bearish market sentiment.
The 'Fear and Greed’-Index is a market sentiment indicator first developed by CNN Money, the TV and online media franchise operated by the TV Network CNN.
The purpose of the Fear & Greed Index is to - as its name eloquently indicates - measure the level of 'Fear' and 'Greed' present in the market.
These emotions are said to be the two primary sentiments displayed by the investing crowd when there is an incoming market top (fear) or an incoming bottom (greed).
The index is used as a sentiment indicator for the broader stock market sentiment and the sentiment for risk assets in general.
The Fear and Greed Index has a relatively complex formulation to calculate whether bullish or bearish sentiment is present in the market.
The following seven inputs deliver a result between 0 (extreme fear or bearish sentiment) and 100 (extreme greed or bullish sentiment).
All of the input factors are all taken in equal weights and are defined as follows:
It is often the case that all of the seven constituents of the index have a positive correlation with one another. For example, if the stock market drops, the market momentum and stock price strength would most likely both drop as well. Similarly, junk bond spreads are likely to be affected by a stock market decline and would increase, indicating more fear.
Thus, the limitation to defining bullish or bearish sentiment with the fear and greed index is, to some extent, represented by the constituting indicators themselves.
As already mentioned, the Fear & Greed Index has a scale from 0 (extremely bearish sentiment) to 100 (extremely bullish sentiment).
As the index is quite volatile, it is difficult to establish a precise level for a highly fearful reading that would serve as a good entry point into the market.
However, CNN Money has set boundaries which qualify any reading below 25 as 'extreme fear' and thus indicating extremely bearish sentiment.
Conversely, any reading above 75 qualifies as 'extreme greed' and indicates an overly bullish sentiment.
However, it is essential to keep in perspective how or if a historical reading of extreme fear translated into corresponding market lows. For example, in 2022, the index had prolonged periods of readings highlighting extreme fear in January, March, May and September. In each of these months, the stock market dropped significantly and made interim lows. However, the market has continued to fall well into September 2022, despite the highly bearish readings at the beginning of the year.
As for extreme greed, which CNN Money qualifies with readings above 75, the index reached a reading above 75 a single time in November 2021 over the previous 52 months, which corresponded to the absolute highs in the Nasdaq-100. Hence, it worked perfectly on that very occasion. We hope everyone noticed it and did sell on time.
A similar index to the CNN version for stocks has been developed for cryptocurrency markets to establish a sentiment indicator to determine bullish and bearish sentiment in crypto markets.
The index works on an analogous calculation formula to the CNN Money Fear and Greed Index. Yet, it attaches additional weights to sentiment indicators on social sentiments, such as Google Trend readings and Social Media sentiment, which are not part of the CNN Money Index.
On the other hand, it omits some of the indicators tied to stock markets and bond spreads exclusively, as it is probably thought that those indicators do not impact the overall crypto market sentiment.
To learn more about the Crypto Fear and Greed index, head to the website alternative.me, which is publishing it.
The Fear & Greed Index has remained popular over many years and is often quoted in the Media when market sentiment is questioned.
Because it aggregates seven different market indicators, which themselves are indications of bullish or bearish investor sentiment, into a single index, it is helpful for market commentators to talk about the overall sentiment of the market.
However, the individual indicators themselves might be highly correlated. Thus, an aggregation probably does not reduce correlation in a meaningful way.
In addition, some of the indicators, such as moving averages, are lagging indicators, thus smoothing the readings over time and making them less extreme when there is an immediate crash.
Another valid criticism is that the index is not ideally suitable for market timing. In a bear market, the readings will probably be depressed and under 25 for a long time while the market keeps dropping.
Nevertheless, since this indicator is highly followed, it is an excellent tool to judge bullish and bearish investor sentiment for the overall market.
The Fear and Greed Index is just one of many ways of calculating and analysing stock sentiment. StockGeist enables traders to access and visualize up to 1 month of AI-processed historical sentiment and ranking data for over 2200 publicly listed companies.
Additionally, StockGeist.ai’s market sentiment monitoring platform allows traders to quickly and efficiently understand news pieces by reading their summarized versions with the most important parts of the text highlighted – all generated by a natural language processing AI model.