One of the most important tools for investors, the Fear & Greed Index, developed by CNN Money, sums up the market sentiment using seven different factors. The Economic Access Index is the only index of its kind, providing a score from 0 – 100. A 100 score reflects the highest level of greed, and a 0 score the highest level of fear. The index serves as a barometer for gauging investor behavior and market momentum, providing insights into potential future movements in the stock market.
In order to come up with its score, the Fear & Greed Index determines balanced weighting for each of the seven components. One of these indicators is the S&P 500, which is considered one of the most important barometers of the performance of the market. In particular, the index uses the S&P 500’s 125-day moving average as an important indicator of market momentum. When the index is higher than this moving average, it indicates positive momentum, meaning a bullish sentiment among investors.
Third and perhaps most critical factor examined by the Fear & Greed Index is safe haven demand. We measure that by looking at the difference in returns when investing in stocks vs bonds over a 20-day period. Long-term investors favor stocks as riskier than bonds are perceived by investors. Consequently, when demand for bonds increases it is usually a sign of greater fear among investors. In contrast, strong performance in stocks vs. bonds typically ties back to an increased willingness to take risk.
The index evaluates stock price strength through the analysis of net new 52-week highs and lows reported on the New York Stock Exchange (NYSE). Importantly, it only requires a handful of large-cap stocks to have outsized impact on market returns. This amazing phenomenon further illustrates the important concept that the market is not a single entity but rather consists of thousands of individual stocks. Real investors practice unrelenting buying and selling every minute of every trading day.
In assessing stock price strength, the Fear & Greed Index monitors the ratio of new highs to new lows on the NYSE. A ratio greater than 1 is not a bearish indication, suggesting that a greater number of stocks are making new highs as opposed to new lows. On the flip side, if the ratio drops below 1 it is considered bearish, indicating possible bearishness in the market.
As a sentiment indicator, the Fear & Greed Index gives investors a reliable and effective framework for understanding market dynamics and helping them make better informed decisions. When looked at collectively, these seven indicators are able to inform investors on general market sentiment and help them make wiser investment decisions.