Many different market sentiment indicators have been developed over time to gauge bullish and bearish sentiment accurately.
However, one indicator, the so-called 'Fear and 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.
What is the stock market Fear and Greed Index?
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 and Greed Index is to - as its name eloquently indicates - measure the level of 'Fear' and 'Greed' present in the stock 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 investor sentiment within the market and the sentiment for risk assets in general.
Calculating the Stock Fear and Greed Index
The stock market 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:
- Market Momentum: measured in the performance of the S&P 500 Index relative to its 125-day average.
- Stock Price Strength: measured by the number of stocks on the New York Stock Exchange (NYSE) hitting 52-week highs relative to those hitting 52-week lows.
- Stock Price Breadth: measured by trading volumes of rising stocks relative to declining stocks on the NYSE, as defined by the McClellan Volume Summation Index.
- Put/Call Ratio: using a 5-day average of the CBOE's total Put/Call ratio.
- Market Volatility: as defined by the CBOE'S VIX Index on a 50-day Moving average basis.
- Safe Haven Demand: measured by the difference in 20-day stock and bond returns.
- Junk Bond Demand: measured by the difference in the yield spread between junk bonds and investment grade bonds.
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 stocks fear and greed index is, to some extent, represented by the constituting indicators themselves.
Which Fear and Greed Index readings are bullish or bearish?
As already mentioned, the stock market Fear and 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.
Fear and Greed Index for Cryptocurrency
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.
Criticisms and Conclusions
The stocks Fear and 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.
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