The Fear and Greed Index, developed by CNNMoney, is used to gauge whether investors are too bullish or bearish on the stock market. The index ranges from 0 (extreme fear) to 100 (extreme greed).
The Fear and Greed Index is a tool used to gauge investor sentiment on the stock market.
The index is based on seven different factors – each factor is gauged from 0 to 100 and equally weighted to generate the index value.
It is seen as less of an investment research tool and more of a market-timing tool.
Understanding the Fear and Greed Index
In theory, the Fear and Greed Index acts as a barometer for whether the stock market is fairly priced by looking at the emotions of investors. It is seen as a contrarian index.
When investors are fearful, they sell stock holdings in their portfolio, driving down stock prices to the point where they may be below their intrinsic value. The opposite is true when investors are greedy. As such, for the Index, fear is seen as a buy indicator, and greed is seen as a sell indicator.
A fear and greed rating of:
0 to 49 indicates fear
50 indicates neutral
51 to 100 indicates greed
Calculation of the Fear and Greed Index
The Fear and Greed Index is based on seven different factors – each factor is gauged from 0 to 100 and equally weighted to generate the index value. The seven factors are:
1. Stock Price Strength
The number of stocks on the New York Stock Exchange (NYSE) hitting 52-week highs relative to those hitting 52-week lows. A greater number of stocks hitting 52-week highs versus 52-weeks lows indicates greed and vice versa.
2. Stock Price Breadth
The trading volumes of rising stocks relative to declining stocks on the NYSE. Greater trading volumes in rising stocks versus declining stocks indicate greed and vice versa.
3. Market Momentum
The performance of the S&P 500 relative to its 125-day average. A greater relative performance indicates greed and vice versa.
4. Put and Call Options
The Chicago Board Options Exchange put/call ratio. A higher put/call ratio indicates fear and vice versa.
5. Safe Haven Demand
The performance of stocks relative to bonds. Greater relative performance indicates greed and vice versa.
6. Junk Bond Demand
The yield spread between investment-grade bonds and junk bonds. A greater yield spread indicates lower junk bond demand (signals fear) and vice versa.
The Fear and Greed Index is commonly used to time entry into the market. As such, the Index is seen as less of an investment research tool and more of a market-timing tool. As stated by Warren Buffet, “Be fearful when others are greedy, and greedy when others are fearful.”
For example, when the index hits a value of 90 (extreme greed), it may signal that stocks are overvalued. It may prompt investors who follow the index to sell their stock holdings.
Question 1: On September 29, 2008, the Dow closed 778 points down, reflecting a 7% loss. Would you assume that the Fear and Greed Index took on a value of (a) 20, (b) 60, or (c) 90 on that day?
Answer 1: The Index likely assumed a value of 20 on that day, as the steep decline would likely reflect fear by investors.
Question 2: Tim is looking to invest in the stock market. Despite his investment advisor advising him not to time the market, Tim thinks otherwise. Based solely on the Fear and Greed Index, which is currently at 95, is it likely that Tim will deploy his capital today?
Answer 2: Since Tim is looking to time entry into the market, he would likely be looking for a low Fear and Greed Index before deploying his capital. As such, given a value of 95 (extreme greed), it is unlikely that Tim will deploy his capital today.
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