What Is the Fear and Greed Index?
The fear and greed index was developed by CNNMoney to measure on a daily, weekly, monthly, and yearly basis two of the primary emotions that influence how much investors are willing to pay for stocks.
In theory, the index can be used to gauge whether the stock market is fairly priced. This is based on the logic that excessive fear tends to drive down share prices, and that too much greed tends to have the opposite effect.
- The fear and greed index was developed by CNNMoney to measure two of the primary emotions that influence how much investors are willing to pay for stocks.
- It is based on the premise that excessive fear can result in stocks trading well below their intrinsic values, and that unbridled greed can result in stocks being bid up far above what they should be worth.
- CNN examines seven different factors to establish how much fear and greed there is in the market, scoring investor sentiment on a scale of 0 to 100.
How the Fear and Greed Index Works
The fear and greed index is a contrarian index of sorts. It is based on the premise that excessive fear can result in stocks trading well below their intrinsic values, and that unbridled greed can result in stocks being bid up far above what they should be worth.
CNN examines seven different factors to establish how much fear and greed there is in the market. They are:
- Stock Price Momentum: Measuring the Standard & Poor's 500 Index (S&P 500) versus its 125-day moving average (MA)
- Stock Price Strength: Calculating the number of stocks hitting 52-week highs versus those hitting 52-week lows on the New York Stock Exchange (NYSE)
- Stock Price Breadth: Analyzing trading volumes in rising stocks against declining stocks
- Put and Call Options: How much do put options lag behind call options, signifying greed, or surpass them, indicating fear
- Junk Bond Demand: Gauging appetite for higher risk strategies by measuring the spread between yields on investment-grade bonds and junk bonds
- Market Volatility: CNN measures the Chicago Board Options Exchange Volatility Index (VIX), concentrating on a 50-day MA
- Safe Haven Demand: The difference in returns for stocks versus treasuries
Each of these seven indicators is measured on a scale from 0 to 100, with the index being computed by taking an equal-weighted average of each of them. A reading of 50 is deemed neutral, while anything higher signals more greed than usual.
Benefits of the Fear and Greed Index
According to some academics, greed, like love, has the power to affect our brains in a way that coerces us to put aside common sense and self-control and thus provoke change. While there is no generally accepted research on the biochemistry of greed, no one can deny that when it comes to humans and money, fear and greed can be powerful motives.
Many investors are emotional and reactionary, and fear and greed are heavy hitters in that arena. These observations, highlighted by behavioral economists and backed by decades of evidence, present a strong case for keeping tabs on CNN’s index.
History shows that the fear and greed index has often been a reliable indicator of a turn in equity markets in the past. For example, the index sank to a low of 12 on Sept. 17, 2008, when the S&P 500 fell to a three-year low in the aftermath of the Lehman Brothers bankruptcy and the near-demise of insurance giant AIG. By contrast, it traded over 90 in September 2012 as global equities rallied following the Federal Reserve's (FED) third round of quantitative easing (QE3).
Plenty of pundits agree that the fear and greed index can come in handy, provided that it is not the only tool used to make investment decisions. Investors are advised to keep tabs on fear for potential buying the dips opportunities and view periods of greed as a potential indicator that stocks might be overvalued.
Criticism of the Fear and Greed Index
They argue that a buy-and-hold strategy is the best way to invest in equities and worry that tools such as the fear and greed index encourage investors to frequently trade in and out of stocks. History, they add, shows that such an approach generates less favorable returns.