Understanding the Fear and Greed Index

Understanding the Fear and Greed Index 1
Understanding the Fear and Greed Index 2Understanding the Fear and Greed Index 3

Fear and greed. These two words are quite often used in combination when it comes to the world of investing. It aptly describes the cycle of market emotions that influences trading on the stock market. As you might have noticed, the impact can be quite dramatic as we’ve seen in recent months.

Riding the Rollercoaster

The year 2020 will go down as a historic year in the stock market. January started off as a continuation of an amazing 11-year bull market. The Dow Jones peaked at a record high of 29,551 on February 12. It seemed like it would go up forever. Market sentiment was high. Extreme greed ruled the day.  

But this was soon followed by a sudden, dramatic downturn on March 9, followed by two more historic drops on March 12 and 16. In just a short period of time, the Dow was down almost 20%. Extreme fear had set in. Investors worried about the impact of the coronavirus pandemic on the economy.  

When Emotions Are Involved

What just happened? You may wonder, as you emerge from shell shock. You would think that trading on the stock market would be a straightforward proposition. Buy a stock based on its intrinsic value. As the company grows and becomes more profitable, the price of its stock should increase. Traders who think the company will do well will have bid the price of the stock up.  At which point you can sell your stock and make a nice profit. As long as you’ve done your homework and chosen wisely, it should be smooth sailing, right?

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Wrong! As we’ve seen in recent weeks, it’s really not that simple.  You see, markets are subject to something called fear and greed. And this occurs because investors on the stock market are actual people, not robots.  So the market is subject to the psychology of the human mind and heart.  

The thing is, when it comes to money, people can actually get quite emotional about it.  After all, money is a necessity in life. It pays for all the basic things we need in order to live, as well as a few of the things that we desire.  The interesting thing about money is, you’re never satisfied with what you have. You always want more. So when greed and fear overtake our brains, it can cause us to put common sense and self-control aside.  It can motivate us to act in irrational ways. This means when it comes time to invest, you may also want to consider building trading psychology for success.

Acting Irrational

The result is the wild market swings that we see plaguing the market during times of exuberance and times of crisis.  It reminds us of the quote from one of Charles Dickens’ novels. “It was the best of times, it was the worst of times.”  Yes, that sums it up nicely.

In his 1986 letter to the shareholders, the great Warren Buffet described fear and greed as diseases that infect investors.  “Occasional outbreaks of those two super-contagious diseases, fear, and greed will forever occur in the investment community.  The timing of these events will be unpredictable. And the market aberrations produced by them will be equally unpredictable, both to duration and degree.”

Fear Sets Into the Market

The recent fear over the coronavirus pandemic is a prime example of how extreme fear has translated into a stock market and altcoin crash.  At the start of the year when everything was going well, greed seemed to be the prevailing emotion. It seemed like, no matter what stock we bought, it was sure to go up. So if we didn’t want to miss out, we had to get in, no matter what the price.  Stocks became overvalued as investors were willing to pay more for a stock than what it was actually worth.  

Then when the coronavirus was labeled a pandemic, fear started to set in. Investors worried about the impact that this virus would have on the economy.  Compounding the fear was the sudden collapse of the global oil market. And the extreme drops in the Dow Jones index. Suddenly, it seemed like the sky was falling. Extreme fear translated to panic selling.  Then it became about getting out, no matter what the cost. And the preservation of capital, to the point of complete capitulation. Funny how that works.

Fearing the Wall in a Bull Market

Having said all that, were there signs that the bull market was about to end?  The “wall of worry” is a common term used in investing to describe the stock market’s ability to keep climbing higher, despite negative news.  This speaks to the resilience of the market. Furthermore, it truly reflects investor confidence that whatever issue or issues the market may face will be overcome. But remember, it is powerful crowd behavior that can drive a market higher.  

The ability to climb the wall of worry is most clearly discernible at the end of bear market trends. It generally results in the market’s advance once the issue is surmounted.  But when it occurs near a market peak, the direction it takes is less certain. It is more than likely that a market decline will follow. 

Climbing the Wall of Worry

During the past bull market, investor sentiment swung often between fear and greed.  As economic, political, and geopolitical issues arose, the markets advanced or declined.   But the overall trend was up. The market was able to climb the wall of worry.  

But as its name implies, the wall of worry is not a peaceful place.  When times are good, investors continually worry about how long those good times will last.  And when the inevitable correction will follow.  

This was demonstrated in the past 11 year bull market.  Despite warnings by market pundits that a correction was inevitable, the market continued to climb the wall of worry.  

Emotions and the Fear and Greed Index

An index that may be useful in gauging market sentiment on a given day is the CNN Fear and Greed Index.  It was developed by CNNMoney.  The index tracks 7 indicators of market sentiment.  It then takes an equally weighted average of each of these indicators, to arrive at a final reading.   The final reading will be on a scale of 0-100. 50 means that market sentiment is neutral. Anything below 50 indicates fear, while anything over 50 indicates greed. 

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The 7 indicators used to determine the final reading are as follows:

  1. Stock price momentum. This tracks the S&P 500 versus its 125-day moving average.
  2. The stock price strength. This looks at the number of stocks hitting 52-week highs and lows on the New York stock exchange
  3. Stock price breadth, which tracks the volume of shares trading in stocks that are rising, versus those declining.
  4. Put and call options, calculated as the put/call ratio.  This compares the trading of bullish call options relative to the trading of bearish put options.
  5. Junk bond demand,  which calculates the spread between the yields on investment-grade bonds and junk bonds.
  6. Market volatility, as determined by the Volatility Index (VIX), which measures the expectation of future volatility
  7. Safe Haven Demand, which is the difference between returns in stocks versus Treasuries

On any given day, one can see what the market sentiment is.  In times of fear, panic selling can drive stock prices too low.  In times of greed, optimism and excitement can cause stock prices to be driven too high.  History has shown that this index can be a reliable indicator of a turn in the market.

Profiting From the Index

So how can we use this index to make money?  As Warren Buffet stated, we should be “fearful when others are greedy and to be greedy when others are fearful.”  In other words, we need to be contrarians.

If we follow this advice,  then we can use the index to guide us in making investment decisions.  The index can help us decide on the best time to enter the market. We can time our entry for when the index dips towards fear.  During times of fear, we can look for quality companies that are undervalued. And we can avoid investing when greed is high. At those times, stocks may have become overvalued.  

On April 2, 2020, the index sat at 21, indicating extreme fear in the market.  This reading has risen only slightly from one month ago when the index was just 10.  This shows that the market still remains fearful of what the future will bring as a result of the fallout from the coronavirus pandemic.  But for long term investors, this may also represent an excellent opportunity to buy oversold quality companies.

Fear and Greed in the Crypto Market

So how are cryptocurrencies faring in the midst of this massive sell-off on the stock market?  As with the stock market, the crypto market is also subject to the emotions of fear and greed. In fact, it can be even more so, as seen in their highly volatile nature.  

When things are going well, the potential to make money can be spectacular.  But when things turn south, the potential is there to lose everything. Because of the hype surrounding cryptocurrency, the market itself can be very subject to crowd behavior.  

When we hear of how some people have become very rich in a short period of time, our greed may cause us to jump right in.  For example, if you had invested $10,000 in Ethereum in January 2017, by June, that investment would be worth $470,000. Those are the kind of returns you can’t get in traditional markets.

The downside, however, can be equally spectacular.  March 12, 2020, saw one of the largest drops in Bitcoin’s price in seven years.  In just eight hours, Bitcoin’s price dropped by 50%, with over $1 billion in longs liquidated.

Gauging Market Sentiment with the Crypto Fear and Greed Index

One way to gauge market sentiment in the crypto market is to look at the Crypto Fear and Greed Index.  This index is published daily and can be found on the website, Alternative.me.  

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The index is currently based on activity in the Bitcoin market.  It looks at indicators from five sources as stated on their website:

  1. Volatility (25%) – takes the maximum drawdown of Bitcoin and compares it with the corresponding average values of the last 30 and 90 days.  An unusual rise in volatility is a sign of a fearful market.
  2. Market momentum/Volume (25%) – measures the current volume and market momentum in comparison with the last 30/90 day average. High buying volumes on a daily basis in a positive market indicates a greedy/bullish market
  3. Social Media (15%) -analyzes Twitter for posts on various hashtags for each coin and checks for how fast and how many interactions are received in certain time frames.  An unusually high interaction rate indicates a growing public interest and greedy market behavior.
  4. Surveys (15%) – weekly polls are conducted on how people view the market in order to get a picture of market sentiment
  5. Dominance (10%) – analyzes the dominance of Bitcoin relative to other alt-coin investments.  A rise in Bitcoin dominance indicates fear as Bitcoin is viewed as the safe haven of crypto. A decline in Bitcoin dominance indicates greed as investors pursue more risky alt-coins.

Consideration of the five indicators results in a number between 0-100.  A number near zero indicates extreme fear. While a number near 100 indicates extreme greed.  In these turbulent times, the Crypto Fear and Greed Index has tended to track the CNN Fear and Greed Index closely.  The index currently reads 14 and indicates extreme fear in the market.  

Coinmarketcap Historical Data

For those interested in seeing the market action in cryptocurrencies, we recommend you check out the Coinmarketcap historical data.  This platform tracks the market capitalization of different cryptocurrencies. It also shows the number of trades and the current price converted to fiat currencies. Yes, you might even refer to this as the holy grail or the crypto world.

Be a Contrarian

As we have seen, fear and greed are two emotions that will always drive the stock market. And blindly following the crowd can cost you dearly.  So control your emotions. Stick to sound investment decisions. And stay the course. You will reach your investment goals if you continue to stick to your well-researched plan.

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