Benedict on “Fear & Greed”

The Mood of the Crowd

There are lots of ways to measure investor sentiment.

Investors need to “be fearful when others are greedy and to be greedy only when others are fearful.
Warren Buffett

Excerpt from Larry Benedict

Some measures are survey-based. You simply ask investors if they’re bullish or bearish on the stock market outlook.

The AAII Investor Sentiment Survey asks investors where the market is heading over the next six months. Just two weeks ago, only 20.6% of respondents held bearish views.

That ranks in the bottom 12% of bearish views historically… and is our first sign that people are leaning toward greed.

Other sentiment measures look at how investors are positioning their portfolios.

For example, we can see the ratio of put options that investors purchase relative to call options.

Put options gain in value when a stock price declines, while call options gain in value when a stock price is increasing.

On October 11, the ratio of puts to calls reached the lowest level in over a year. A low reading indicates greed, as investors scoop up call options compared to puts.

Additionally, CNN’s Fear & Greed Index is another useful measure. It lumps together seven indicators of fear and greed. They are market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand.

Here’s the index over the past year. A high value indicates greed, while a low value points to fear:

Fear & Greed Index Timeline

Source: CNN

Since the start of October, you can see the Fear & Greed Index has been creeping ever nearer to “extreme greed” territory.

We haven’t quite crossed over the line yet. But it’s becoming clear that investor sentiment is leaning too much toward greed at the moment.

Here’s why that’s a big problem heading into November…

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Volatility Overdrive

When extreme greed collides with rising volatility, that’s a sign of too much complacency in the stock market. It’s a recipe for a pullback.

And alongside the current exuberance, we’re seeing hints that volatility is on the move.

A key recession signal was triggered in early September. At the same time, the S&P 500 is entering a period that has historically seen a sharp rise in volatility.

Add in a contentious election right around the corner, and we’re facing the strong possibility of what I call a “chaos period.”

In the past, chaos periods have led to flailing markets.

We don’t even need to see a crash to know there’s trouble ahead. Investors could even experience years of lost gains for their portfolio. Anyone facing retirement soon should be especially cautious