fear or greed

Are You Fearful or Greedy: A Look at Market Sentiment

“The market’s job is to inflict the most pain on the greatest number of people at any given time.” 

I am not sure who made this quote famous but I heard it a long time ago and it has stuck with me through the years. Every Wednesday in my note for clients I take look at sentiment in the market to get an understanding of how investors “feel” about the market. Are they bullish, bearish or neutral? More often than not, there is not a lot to be taken away from the findings but I monitor them weekly to try to identify the changes in sentiment as early as possible. What I have found is that sentiment is usually a poor timing tool but is most useful at the extremes. But what does that mean?

Getting back to the quote above, the sentiment indicators that I track tend to send the best signals when a large majority of investors are caught leaning in the same direction, either overly bullish or overly bearish. But how do I know which way the large majority is leaning. 

Put / Call Ratio:

I look at the CBOE Put / Call Ratio because when investors are nervous about the market and think that it is due to fall, they have a tendency to gravitate toward put options to protect their portfolios or to bet on downside in the market. If they are bullish, they tend to buy calls. 

Here is the data on a daily basis over the past five years. Honestly, it is hard to infer much from the daily data because it is extremely volatile. But we can see that spikes to the upside tend to coincide with lows in the S&P 500 and spikes to the downside tend to align with near-term highs for the index. 

There has to be a better way to get a clearer look at the data. So as a technical analyst, I can go to the tools that I use to analyse the market to make the data a little more “readable.” In this case, I smooth out the daily fluctuations in the ratio with a 13-period moving average. I know that most people use 10 days but I am technical analysis “geek” and 13 is a Fibonacci number. 

With the moving average, the data become more manageable and we can begin to look for extremes in the average to get a sense of how investors are positioned. We can quickly see that spikes above the 1.1 level tend to signal a near-term low in the market. It makes sense, when investors are extremely cautious, the market tends to do the opposite of what everyone expects. The market does it’s job of inflicting pain on the bears when “everyone” is bearish. 

The bulls are not immune here. Though the average tends to reach the lower extreme of 0.85 less often than the higher extreme, when it does, it is usually a sign of a near-term top in the market.  The average is getting close to that level now.  

Interestingly, when the 13-day moving average of the Put / Call ratio is greater than 1.1, the probability of gain over the next month is 76% for the S&P 500 and the median return is 2.75%. When the average is below 0.85, the probability of gain over the next month falls to 68% for a median return of 1.07%. 

CNN Fear & Greed Index:

Every day, the team at CNN, gives us a way to measure which emotion (fear or greed) is pervasive in the market. You can read more about it here. The index is made of seven different inputs to arrive at a final number between 0 (extreme fear) and 100 (extreme greed). 

They also allow us to look back over the past few years to see what the reading had been. Again, this gauge is most useful at extremes. How did you feel about the market and your investments last December? The Fear & Greed Index was in a position of extreme fear when the market bottomed in late December. Notice the “Extreme Greed” position now. 

What About Sentiment Surveys?

The American Association of Individual Investors publishes the results of a weekly survey where they ask their members if they are bullish, neutral or bearish on the market over the next six months. Here are the results for October 30th:

As with other sentiment measures, this one is more useful when the readings are at extremes. While I do find the survey to be somewhat useful, there can be a disconnect between what people say and what they are actually doing with their money. That’s why I prefer the first two indicators. The Put / Call ratio and the Fear & Greed Index use actual market data as inputs…what people are doing, not what they are saying.  

Now What?

We can clearly see that sentiment is very bullish based on the Put / Call ratio and the Fear & Greed Index. It is not surprising to see these readings with the market at all-time highs. The readings also coincide with our Overbought / Oversold Indicator for the SPDR S&P 500 Fund (SPY) being in a near-term overbought condition.

Does this mean that you should log in to your account and sell everything? Of course not. The fund still has a  Bullish ETF rating and is in an uptrend. It does, however, mean that it may make sense to be less aggressive with adding new ideas to the portfolio until there is a better tactical setup in the market, meaning the overbought condition has been alleviated and sentiment is not as frothy as it is now. 

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1 thought on “Are You Fearful or Greedy: A Look at Market Sentiment”

  1. Good morning Dan,
    Very well explained and clarified article, thanks you are great and very helpful in educating novice people like me, May God bless you.

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