The Fear and Greed Index is an essential tool for any investor. It uses seven market indicators to measure the fear and greed that’s at work in driving the U.S. stock market today. The index compares multiple economic, social, and environmental metrics to produce an overall score from 0 to 100. A value of 100 means the market is currently in a state of highest greed, and 0 the highest fear. This score has functioned as a barometer for bullish vs. bearish market sentiment, allowing investors to get a good feel for when the market is overbought or oversold.
The index weights each of the seven indicators equally. Among these indicators are safe haven demand, stock price strength, market momentum, net new 52-week highs and lows on the NYSE. Each one of these components is extremely important in establishing the overall mood as shown in the index.
Perhaps the most important indicator in the index is safe haven demand. This is designed to capture how much investors flock to lower risk assets during times of market distress. When investors run to safer investments like government bonds, it often indicates a lot of fear in the market. On the other hand, slack demand for safe havens might be a sign that investors are feeling more risk-on — in other words, they’re feeling more greed.
The final, but perhaps most important of these, is the expected excess return of equity over bond, measured over a 20-day horizon. This seemingly benign comparison goes to the heart of investors’ risk appetite, as stocks are almost universally understood to be riskier than bonds. An observed divergence in performance can be the first indicator of changing tides that traders should be paying attention to.
Stock price strength is one of the six components of the Fear and Greed Index. Analysts measure this underlying strength by looking at the S&P 500’s performance compared to its 125-day moving average. When the S&P 500 is above this moving average, that indicates very strong positive momentum in the market. This explosion indicates that bullish feelings will be determined to control trading action.
Market momentum in itself is determined by the S&P 500 and its 125-day moving average. If prices can’t fall below the moving average and keep breaking to the upside, that creates a very bullish phenomenon. This is typical in times of investor speculation. On the other hand, when prices start falling under the moving average, this can be an indicator of growing fear and uncertainty.
The index uses net new 52-week highs and lows on the NYSE as a measure of market breadth. A high ratio of new highs to new lows indicates bullish market breadth. Yet whenever new lows start to rise, it’s usually a harbinger of bearish proclivities. This ratio can be misleading as well, since if a handful of big stocks catch a bid, they can skew overall market returns by a wide margin.
Additionally, the Fear and Greed Index relies on one metric, a ratio of stocks, to determine bullish or bearish trends. Just as a fundamental risk indicator, any ratio above 1 should be viewed as bearish, pointing to increasing risks in the market. This new metric gives investors the opportunity to see if these bigger trends are playing out with specific stocks.
It’s helpful to look at today’s stock market levels relative to where they’ve gone over the last few months. That kind of analysis can help put today’s valuations in context and help investors make more informed decisions, rooted in lessons from the past.