Whenever you hear people making predictions about what will happen in markets, I would advise you to grab your money and slowly back away. Next, run as fast as you can in the opposite direction. Once you are in a safe place away from all the prognosticators and future tellers, collect your thoughts. There’s plenty of data giving investors a chance to make their own informed decisions. Some are better than others. Let’s take a look at a few market indicators and go beyond the CNN Fear & Greed Index.
While it’s not a great idea to think you can predict what will happen in markets, one thing you should know is where we stand today and where we’ve come. Two emotions, fear and greed, primarily drive investors. When investors are greedy, the prices for assets can get bid up way beyond what is a reasonable and fair price.
When there’s too much fear in markets, prices can sink below where they should be, and great deals can be had. An interesting index I’ve watched is the CNN Money Fear & Greed Index. This is not a predictor of the future and certainly not a trading device for timing markets. It’s merely an index combining seven useful indicators of investor’s appetite for risk. A lack thereof can be informative, as well.
The 7 Indicators
The CNNMoney’s Fear & Greed Index looks at seven market indicators. Each indicator is tracked for how far they are from their average. The index uses a scale from 0 to 100. The higher the reading, the higher the greed of investors with 50 as neutral. Back in the depths of hell during the financial crisis in September of 2008, the index rang in at a fearful 12. Later, when cooler heads would prevail, the economy began to recover in 2012. Stocks and markets, in general, began to go on an epic run. The CNN Fear & Greed index would skyrocket to the upper 90’s.
So what goes into a simple gauge of investor emotion? There are hundreds of indexes and indicators you could choose to show the everyday ebb and flow of money in global markets. CNNMoney’s Fear and Greed chose seven indicators to blend into their index recipe.
Stock Price Strength
Stock Price Strength is the number of stocks on the New York Stock Exchange hitting their 52-week highs. If more stocks are hitting new highs than stocks hitting new lows, it would indicate greed in the markets. At the moment, there are 165 new 52-week highs on the NYSE and only 23 new 52-week lows. You can find the complete list of companies here. As you can see in the chart above, the index is in Extreme Greed territory. The NYSE is showing stock price strength currently.
Market Momentum is the S&P 500 index versus its 125-day moving average. This is simply how far above or below stocks are from their not too distant past. The higher the S&P index gets from the 125-day moving average, the higher it scores on the CNN Fear & Greed Index rating. On the other hand, when fear strikes the S&P plummets. When the index drops below the 125-day moving average, the lower score will compute as fear into the Fear & Greed Index. The index also breaks down the most recent analysis and gives the previous reading and the date the last reading occurred.
Safe Haven Demand
Safe Haven Demand is the difference in 20-day stock and bond returns. When stocks outperform bonds over the last 20 days, it indicates an appetite for riskier assets. A more greedy atmosphere in the financial markets is underway. Bonds are considered a safe haven, and when fear strikes, bonds are more desirable, and stocks would go down. At the current reading, stocks are outperforming bonds. At nearly the strongest margin over the last two years, there’s more greed and less extreme fear in general.
In times of market turbulence, a safe haven is an investment that retains or increases its value. You may be asking yourself why bonds are considered safer than stocks, and the answer is not always clear. One of the most common solutions would be the fact that corporate bond coupon payments are considered more stable than company dividend payments.
Put and Call Options
Another useful indicator in markets for gauging the optimism or pessimism at a given time is the Put to Call Ratio. The CBOE 5-day average put/call ratio tracks the daily volume of options purchased. The put/call ratio indicates investor sentiment among traders. This ratio is known as a contrarian measure. Too many call option buyers would signal a market top may be in the making. If traders buy too many put options, the possibility of a market bottom is more likely.
A useful exercise is to look at a long term chart of the Put/Call Ratio and see where the index registered at market extremes. One thing to keep in mind is that historically the option index has been skewed toward more put buying that call buying because of hedging by portfolio managers. At the current reading, the volume of put options has lagged volume of call options by over 37%. This happens to be the lowest level of put buying over the last two years, showing greed in markets.
Stock Price Breadth
Stock Price Breadth shows volume in advancing stocks relative to declining stocks. The McClellan Volume Summation Index tracks advancing and declining volume on the New York Stock Exchange over the last month. This is to indicate strength or weakness. Over the previous month, 12% of each day’s volume on the NYSE has traded in advancing issues rather than declining issues. The rising volume of advancing issues shows an appetite for greed over fear.
The VIX, along with it’s 50-day moving average, can reveal extreme fear among investors. It’s the expectation of market volatility implied by the S&P 500 index options and calculated on a real-time basis by the Chicago Board Options Exchange. If the VIX is above it’s 50-day moving average investor’s fear may be increasing. If the index falls below it’s 50-day moving average, the market is showing a less fearful atmosphere. Market crashes and panics have coincided with a spike in the VIX to extreme levels. This would indicate the height in investor’s fear and market volatility.
Junk Bond Demand
When investors look to riskier investments like junk bonds, it can indicate a greedy atmosphere. The Yield Spread tracks junk bond demand vs. investment-grade corporate bonds. Buyers receive a higher yield for junk bonds. The reason being the risk of default is higher for junk bonds relative to investment-grade bonds. When the yield spread falls, it shows an appetite for risk. Investors are less worried about default and greedy for higher returns, causing them to accept less compensation for more risky junk bonds. A fearful market would demand a much higher yield on junk bonds. This is relative to investment-grade bonds and therefore sends the yield spread higher.
Market Emotions and The Fear & Greed Index
You hear the words fear & greed in investing almost more than any other combination of words. Warren Buffett did an excellent job promoting the phrase when he said to, “Be fearful when others are greedy and greedy when others are fearful.” He mumbled these words probably around the time of his first television interview back in the mid-1980s, and the phrase has been gaining popularity since then.
Markets can swing from fear to greed many times throughout a given year. Over the long term, patterns emerge where investors let their emotions make decisions for them. The chart below shows a clear portrayal of a full cycle of market emotions. Beginning with optimism and excitement, prices are bid up, and things look safe, and profits are easy.
Easy profits lead to thrill and eventually euphoria as everyone is convinced the good times will never end. As thoughts turn, anxiety grows, and there’s a denial that the good times are over.
As the market continues to fall, fear sets in, and desperation turns to panic. Emotions take control at the extremes where capitulation and despondency are widespread. Markets now acknowledge the fact that things are bad with no end in sight. Depression sets in among market participants, where the thought of higher prices seems impossible. This is where recovery is born, and there are no more sellers to be found. The turning point begins, and hope is renewed. Some relief and soon after, a touch of optimism can be found where the cycle is now complete.
The cycle of market emotions happens over and over, year after year, decade after decade. As long as people are participating in markets, there will be a similar cycle in the years to come.
Why Do Stocks Fall Faster Than They Rise?
Generally, stocks will fall in price faster than they rise. There’s a variety of factors that cause selloffs to happen quicker than gains. One of the primary reasons the stock market declines faster is because of leverage. Some investors buy stocks with borrowed money, and when stocks decline some are forced to sell to meet mandatory margin calls demanded by the brokerage houses. If investors do not sell to meet the margin call, the broker will sell automatically for them.
Another reason stocks fall faster than they rise is due to human emotion. Gains in stocks are enjoyed over the long-term, hypothetically. We get accustomed to watching these gains month after month, year after year. We are almost trained to expect our money to grow over time in the stock market, on a long time horizon.
Emotions Deep Within the Brain
The human emotion factor plays a part in stock market declines because the loss of money can be more than gains. People tend to panic sell to avoid this pain. Watching your gains evaporate is considered by many, and studies have shown this, to be more painful than the market gains.
A recent study published in the Journal of Neuroscience showed that losing money activated an area in the brain involved in fear and pain. Researches used MRI brain scanners to monitor healthy adults playing a gambling game, and how they reacted to winning or losing.
Deep within the brain, an area called the striatum attempts to predict the chances of winning or losing money. Scientists called this act the “prediction error,” where the brain learns to predict based on previous mistakes.
Behavioral Finance and Fear & Greed
The study of behavioral finance focuses on psychological factors that impact market outcomes. This fascinating field is broad and covers a huge variety of topics. Research in this field is really just getting started, but much of it can explain why the stock market falls faster than it rises.
The fear of losing money is much bigger than the excitement of gains, this pattern has been observed over and over. Not only is the pain of loss something investors fear, the pain from accepting they have made a bad decision is almost as painful. With the human brain wired with certain biases, markets tend to react quickly to this fear and pain.