Be Fearful When Others Are Greedy

Warren Buffett once said, investors should be “Fearful when others are greedy and greedy when others are fearful.” There is a lot of wisdom to this statement and it is somewhat a contrarian view to investing.

The stock markets continue to rise despite the world facing the worst health crisis – COVID 19. Investors are asking whether they have missed the boat (FOMO – Fear of Missing Out) and should jump on the bandwagon. There is another camp that calls this a “dead cat bounce”, which simply means a rally within a downturn that will end with another more severe sell down.

Objectively, we will only know in hindsight whether the bulls or bears are right. Investing and trading is about stacking as much probability in our favour. Today, let us look at an interesting indicator on Fear vs Greed.

Fear & Greed Index

The fear and greed index was developed by CNNMoney to determine the 2 main emotions that drives stock prices.

Investors are driven by two emotions: fear and greed. Too much fear can cause stocks to trade the underlying valuation (under-valued). When investors get greedy, they can drive up stock prices way too far, resulting in stocks being over-valued.

CNN incorporates seven different factors (equally weighted) to derive the level of fear and greed in the market, on a scale of 0 to 100.

1. Stock Price Momentum: The S&P 500 (SPX) versus its 125-day moving average
2. Market Volatility: The VIX (VIX), which measures volatility
3. Stock Price Strength: Number of stocks hitting 52-week highs and lows on the New York Stock Exchange
4. Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options
5. Stock Price Breadth: Volume of shares trading in stocks on the rise versus those declining.
6. Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
7. Safe Haven Demand: The difference in returns for stocks versus Treasuries

The fear and greed index can be found at: https://money.cnn.com/data/fear-and-greed/

Source: CNN Money

What it means in looking back

Anything over a 55 indicates Greed, while a reading below 45 suggests a level of Fear.

CNN provides three years of historical chart data on its website.

The index plunged into Extreme Fear territory in March 2020, as the Covid-19 pandemic led to massive shutdowns across the world: countries were in lock down state, planes were grounded, closure of schools, the suspension of live sports and entertainment and many people being forced to work from home. The index hit a low of 2 on March 12.

Source: CNN Money

When the S&P 500 dropped to a low on Sept. 17, 2008 at the peak of the financial crisis, the Fear and Greed index sank to 12. The index gained increased to 28 before stocks finally bottomed out on March 9, 2009 and the bull market began.

Source: CNN Money

Bottomline

While the index shows the current sentiment in the markets, investors should be cautious not to use it as the only indicator to time the market. It gives an indication on being “Fearful when others are greedy and greedy when others are fearful.”

Combined with other tools and analysis which I will be introducing, hopefully it gives you a good toolbox to make your journey in investing safe and rewarding.