Part of being a successful investor is recognizing important inflection points in market sentiment. When prices and valuations are stretched and you start to get stock tips from your barber, it may make sense to trim risk, raise cash, and become defensive. On the other hand, when investors are in panic mode and selling stocks indiscriminately, it’s probably a good time to put together your shopping list and do some buying.
Investor sentiment clearly moves in cycles and is best captured in the above graphic.
When we speak of fear and greed, a natural question emerges: Is there a way to quantify investor sentiment so as to make it measurable and meaningful across time? The answer of course, is yes. There are many statistics that can be useful when measuring fear and greed, including the put/call ratio, VIX, investment advisor bull/bear ratios, mutual fund flows, and many others.
I have found that CNN’s Fear & Greed Index does a good job at capturing the most important variables pertaining to investor sentiment. It is updated regularly throughout the course of the trading day and will range in value from 0 (extreme fear) to 100 (extreme greed).
Below, I identify and help to explain the rational of some of the major variables that are included in the Fear & Greed Index.
Junk Bond Demand – When yields on junk bonds relative to safer bonds widens, investors are fearful of taking on additional risk.
VIX – VIX is derived using the Black Scholes model. Given the observed prices of puts and calls in the market, we can use reverse engineering to calculate expected volatility. When investors are fearful, VIX will begin to rise in value.
Put – Call Ratio – When investors are buying more puts relative to calls, they are concerned about falling prices. Conversely, when investors are buying more calls relative to puts, they are exhibiting a higher risk appetite.
Many years ago, Warren Buffett once said “Be fearful when others are greedy and be greedy when others are fearful.” The same is true in 2018 as it was in 1637……..when the Tulip Mania finally peaked and then suddenly crashed.
Please note, the information contained in this segment is for educational purposes only and does not represent a solicitation or recommendation to buy any security that is mentioned.
Thomas A. McDevitt, CFA, CFP, EA