Everything You Ever Wanted to Know About the CNN Fear & Greed Index
I used to joke that I was the world’s most widely read analyst, if not the best. You see, for nearly 20 years, I worked in Fintech, where I built dynamically generated investment analyses that you may have read on media outlets like the NY Times, CNN, and the Financial Times or online brokers like Schwab, TD Ameritrade, and Merrill. While I don't consider myself the world's best analyst, my work remains widely used and popular.
You may be familiar with CNN’s Fear & Greed Index. I built that. It was CNN’s idea, but the model behind Fear & Greed is based on work I’d been doing since business school and I’d like to tell you about it before we analyze what it's saying right now.
Let's begin with a story that formed how I look at markets.
Maybe you remember JDS Uniphase, or JDSU. It was one of those companies that built the backbone of the internet and, in 1999, it was one of the hottest stocks out there.
I was a young market maker with a personal stake in JDSU. I was also getting an MBA at night and selected JDSU to research for my valuation class.
I don’t remember the exact prices or dates, but I believe that in February 2000, JDSU was trading around $125, up from less than $25 just six months earlier. And there was talk of it being added to the S&P 500.
My team was tasked with using Discounted Cash Flow analysis, or DCF, to determine the fair value for the stock. This is what many analysts do. DCF is a simple formula that uses your projections of future cash flows to come up with a current fair value for an asset.
DCF, like many investment tools, has one major flaw. Any biases that the analyst has, will show up in the final result. In the case of DCF, analysts must determine a future growth rate for a company’s cash flows. Now, I may be able to reliably forecast growth in one year, but how about in five years …or 10? It’s why the best analysts constantly reevaluate their work. It’s a full-time job.
As we started our DCF of JDSU, we made reasonable assumptions about the company’s future growth, based on its current performance.
Then, we calculated JDSU’s fair value. We were pretty excited to hit enter and see what the result was. Can you guess?
A measly $2.25.
By this point, the stock was trading at over $165, so we believed that our assumptions were wrong. The market was efficient, after all!
For our second try, we assumed that the company would grow by 50% annually, forever, which is insane. Our new target price was $225, which made our professor laugh out loud. He countered that (AAPL) was a better bet and I hope he’s retired to a tropical island somewhere.
Was the company worth $2.25 or $225?
Shares topped in March at around $235. I sold out at $225. So, we were right on our $225 call.
But, we were also right about $2.25. You see, as the Dotcom Bust gained steam, JDSU tumbled below $2.
Yup, we were right about $225 and we were right about $2.25.
My takeaway was that everything in investing is based on sentiment. Anything that requires the investor to make an estimate will be influenced by their biases. Seasoned analysts know this and have the experience to remove some of that bias. But nobody can remove all of it. Reading that sentiment is the most powerful tool investors have.
There are two types of sentiment, social and market.
Social sentiment is simple. It’s what people say that they’re doing. HODL and Diamond Hands are Reddit lingo for being bullish. The thing is, just because I say I’m HODLing doesn’t mean that I’m not actually selling! The internet is fickle!
That brings us to market sentiment. Market sentiment is based on data and measures what investors are actually doing. Data are not fickle.
Birth of the Fear & Greed Index
Fast forward to 2012, and I was working with CNN to build the Fear & Greed Index.
The Fear & Greed Index is a tool to measure market sentiment. It uses seven indicators that help us to understand if investors are committing new money to the market, and how risk averse they may be.
The seven components of Fear & Greed were taken from across stocks, bonds, and options, and our goal was to create a mathematical version of the cycle of investor emotions, to understand when investors might be too greedy or too fearful.
Fear & Greed is not a trading system. It’s a framework to understand market sentiment, which can help us reign in our own biases.
For example, one financial advisor uses it with clients. When they are scared and want to sell, he reminds them to look at Fear & Greed and to stray from the herd.
Are Investors Fearful or Greedy Right Now and What Does That Mean?
Let’s take a quick look at today’s Fear & Greed Index to see what investors are thinking.
https://www.cnn.com/markets/fear-and-greed
Investors are fearful. They’re selling stocks and increasing allocations towards less risky assets. The thing is, the S&P 500 has been hitting new all-time highs. So, while most people end their analysis of Fear & Greed with the speed dial at the top, we should take a look at the components to see if they can shed some light.
Market Momentum
https://www.cnn.com/markets/fear-and-greed
Market Momentum is based on the trend and momentum of the S&P 500. It’s normalized so that greedy levels are relative to the history over the last two years.
Its Extreme Greed indication shows us that the S&P 500 is substantially above its 125-day average. In fact, it’s among the highest it’s been for the last two years. Investors have been incredibly bullish and have committed lots of new capital to mega-caps. Do they have any fuel left to keep the fire burning?
Stock Price Strength
https://www.cnn.com/markets/fear-and-greed
Stock Price Strength is the first of two measures of market breadth. This one looks at new 52-week highs and lows on the NYSE.
When Stock Price Strength reads Extreme Fear, it’s because investors are buying only a handful of names. Most stocks are not participating in the rally.
Stock Price Breadth
https://www.cnn.com/markets/fear-and-greed
Similar to Stock Price Strength, Stock Price Breadth is a breadth indicator that measures volume flows into up vs. down stocks.
Our second breadth indicator is showing Extreme Fear. The decline in this indicator tells us that volume in down stocks (selling) has been more broad than volume in up stocks (buying). Again, most stocks are not participating in this rally.
Put and Call Options
https://www.cnn.com/markets/fear-and-greed
Put and Call Options is the first of two options-related indicators. It’s actually the 5-day average of the Put/Call ratio and tells us if investors are making bullish bets or are buying puts to protect their portfolios.
The Extreme Greed reading on Put and Call Options shows that investors are speculating using options. They’re trading lots of call options in the hope that the market continues to rally.
Market Volatility
https://www.cnn.com/markets/fear-and-greed
Market Volatility reads the VIX to see if it’s spiking or not. A spike means that investors are fearful and the Market Volatility indicator will reflect that. Otherwise, we leave the VIX out.
The VIX is pretty low, indicating that investors are not hedging their portfolios. When this happens, we ignore the VIX. No signal.
Safe Haven Demand
https://www.cnn.com/markets/fear-and-greed
Safe Haven Demand compares the returns on stocks and bonds to see if investors are risk loving or risk averse.
Extreme Fear for Safe Haven Demand indicates that bonds are performing well, relative to stocks. So, even though the S&P is near all-time highs, investors are allocating money towards lower risk bonds.
Junk Bond Demand
https://www.cnn.com/markets/fear-and-greed
Junk Bond Demand is another measure of the bond market, but it compares the yield of junk bonds to the yield on investment grade corporates.
Check the chart’s footnote on this one. I’ve let CNN know that their version of the indicator is a little off, based on those spikes. That said, I think the current Fear rating is probably reasonable, since the spread in yield between low quality junk and high-quality investment-grade corporate bonds has begun to widen again. In other words, investors are selling the risky stuff and reallocating towards the less risky stuff.
Putting It All Together
Fear & Greed tells us that investors are worried. And that’s bad! Or maybe it’s good!
Well, of the seven indicators, we’ve learned that the S&P’s rally has been driven by only a handful of stocks. Most investors are probably losing money on most of their holdings. It’s a safe bet that they’re underperforming index funds! And, they’re reallocating towards lower risk assets. And yet, they’re still speculating using options. Maybe, they’re just selling options to generate income. I can’t be sure. In general, though, investors appear cautious.
Fear & Greed can give great signals (again, not a trading system) when it’s at extremes. But, that’s not the case today. So, what is it telling us?
Let’s compare Fear & Greed to the S&P 500.
https://en.macromicro.me/
Right now, Fear & Greed is not confirming the market’s highs. It’s dropping while the S&P 500 is rallying. It did something similar in 2022, before the S&P 500 fell by over 20%. Will that happen again? I have no idea. But I do know that this is not a low-risk time to invest new money.
Thanks for reading and please feel free to leave me a comment or question.