Fear and greed: the market cycle and what the signals are currently telling investors

“Greed, for lack of a better word, is good”.
Quoted by ruthless film character Gordon Gekko in the film Wall Street (and probably millions of investors in the current cycle).

It’s amazing what you can tell about the market cycle and behaviour simply by investor sentiment. In some cases, it can also offer helpful information about what might come next.

Fear and greed are two key psychological drivers of market activity.

When investors are fearful, they are more likely to sell and less likely to re-enter the market, while when investors are greedy, they are more likely to buy and make speculative choices. The former can push down market prices, while the latter can drive up share prices.

Currently, the CNN Fear and Greed Index is standing at Greed, yet only a month ago, investors were looking fearful.

What’s going on and how does this link back to market activity?

The Fear and Greed Index

For those not in the know, the CNN Fear and Greed Index is a group of seven different indicators to measure stock market behaviour in the US. The average of these indicators gives an overall measure ranging between Extreme Fear and Extreme Greed.

The indicators include Market Momentum, Stock Price Strength, Stock Price Breadth, Put and Call Options, Market Volatility, Safe Haven Demand and Junk Bond Demand.

It’s not a static tool – and you can see in the chart above that investor sentiment can swing quite rapidly in short periods. The current figure is 58, positioning sentiment in Greed.

Looking deeper into the underlying indices, the US stock market is pushing into momentum territory (Greed), safe haven demand is in Greed territory (aka investors are more focused on stocks than bonds), and junk bond demand has reached Extreme Greed (more speculative behaviour. Investors are favouring bonds with a higher risk of default in return for higher yield over safer government bonds.)

By contrast, the market volatility index is neutral, put and call options are neutral while inidcators for stock price strength and breadth are showing fear. It’s worth noting though that a number of large US conglomerates are about to report so this may be more a matter of holding breath for results rather than genuine concerns.

Australia has its own version of the index – the MacroMicro Australia Fear and Greed Index.

As the saying goes, America sneezes and the world catches a cold. Likewise, Australian investors trend fairly similarly to their US counterparts. What is also interesting is the overlay of the All-Ordinaries Index which peaks and troughs at relatively similar times to the fear and greed index.

Fear and greed and the market cycle

Fear and greed can map within market cycles and there have been many notable examples of where this is exactly what has played out.

The cycle is mapped in the below diagram from Peccala:

The dotcom bubble saw extreme greed play into internet companies and many companies had fundamentals that didn’t justify valuations or prices. Eventually companies failed to return on expectations and the bubble burst. The result? Panic selling and movement into extreme fear as the market troughed. Then? Slow recovery and rebuild.

The GFC is a similar story as investors bought into the US housing boom and risky lending. When the poor fundamentals were revealed, mass sell-offs occurred and pushed the economy into recession.

There have been some concerns that the AI-boom could follow a similar trajectory to the dotcom bubble, given the market is heavily concentrated in mega-cap tech firms with large-scale AI development spend.

At this stage, the market appears to be in the mid-cycle of a bull market and surges have some substance to them in terms of earnings and fundamentals rather than speculation, according to experts like Invesco’s Brian Levitt, or as discussed in Fidelity’s article Can the stock market keep reaching all-time highs?

What this all means for market activity now?

The fact that the Fear and Greed Index stands at Greed right at this moment doesn’t necessarily mean that investors should be concerned right now though. There can be small movement all the time – the market can have small dips and peaks constantly too.

Only a month ago, the index was in fear territory and there are a few key drivers pushing investment sentiment upwards currently.

• The S&P 500 hit new highs this week off the back of renewed hopes for a peace deal between US and Iran, which also pushed down oil prices. Several corporate earnings reports also offered unexpected strength, including Palantir.
• Locally, while financials fell, BHP’s $200m contract news pushed the ASX200 upwards.
• Economic data has been supportive of stock markets, with a slight fall in inflation data next to resilient household spending.

Investors using the index might find it a helpful explanation for trading activity – investors are veering on greed so there is likely to be more speculative behaviour pushing the indices upwards. It’s not a guarantee of what happens next, although it’s fair to assume that what goes up must come down so at some point, investors will switch and there will be some level of fall or correction. To be clear – that doesn’t mean there will be a crash, just that nothing lasts forever.

How to use fear and greed in your own trading

Investors like to follow the Warren Buffett quote: Be fearful when others are greedy, and greedy when others are fearful.

There’s more to the story though – Buffett never advocated buying blindly, but sticking to fundamentals and valuations.

The fear and greed index can be an additional tool in your belt, rather than the main tool.

While knowing that the market is in fearful territory may open up opportunity, it equally may not.

If you know that the market is in greed territory, it can be a good time to revisit valuations and fundamentals before buying. Seeing that the market has reached Extreme Greed may be an opportunity to take stock, revisit your strategy and consider whether it is worth holding back before making purchases. It might also support contrarian theses when sentiment has moved to Extreme Fear.

It is a short-term measure and can move quickly so it is best to avoid using it as a long-term approach and it is helpful to match the measure against broader activity and geopolitical events as an interpretative tool.

Where do you sit on the fear and greed index? Let us know where in the comments and if you are buying, what looks attractive to you.