Have you ever seen old movies with people screaming and throwing their hands around on Wall Street? All the yelling and hand waving is called open outcry.
The screaming and specific hand signs conveyed information for buying and selling orders. Its popularity waned with the advent of electronic trading. But it did make it easy to tell how other traders felt about the market.
This ability to read emotion -- or investor sentiment analysis -- helps guess future return investments. Of course, the more modern Fear and Greed Index does much the same -- without the loud crowd of traders.
Making headway with stocks and trading relies more on emotion than you think. Today, we're going to dive into the Fear and Greed gauge.
We'll explore what it is, how it works, and why understanding it matters. We'll also discuss what role emotion plays in the market.
Stock Market Emotions: The Good and the Bad
The first thing we should go over is the market sentiment index. A market sentiment index (or sentiment indicator) is a tool used to measure how a group feels about the market or economy as a whole.
Sentiment indicators use market psychology to measure people's financial behavior. Market analysts and media use the term "market psychology" to quantify market movement unexplainable by other metrics.
A sentiment indicator uses figures and graphs to gauge how investor beliefs and positions may impact future market behavior. Specifically, investor sentiment analysis monitors bull and bear's thoughts and feelings.
What Is Market Sentiment?
You've read the words "market" and "sentiment" a lot. But what do they mean and what do they have to do with each other? "Market" here means the stock market -- but sentiment refers to investor attitudes.
Particularly attitudes toward a market, asset class, or sector. First, a quick aside -- "market" in this context refers to an area where commercial dealings happen. An example is the hospitality market.
An asset class is a group of similarly grouped investments subject to the same regulations and laws. Some asset classes include cash equivalents (liquid short-term investments), fixed income, and stocks.
Sectors are stock groups that share commonalities, often because they're in similar industries. Getting back on track, market sentiment comes from and is influenced by various sources, including:
- - Seasonal factors
- - Economic reports
- - National and international world events
- - Investor behavior
- - Political events
- - Company news
Bulls and Bears: Following Market Trends
We started talking about bulls and bears, but what do those terms mean? Bulls think the market, certain securities, or industries will rise. "Rise," means stock prices and market values will increase.
Bulls will purchase these securities with the expectation they can sell them for higher prices later. Securities refer to investments like stocks, bonds, and contracts.
Optimism is a key characteristic of bullish investing. These people intend to profit from upward mobility within the market.
Not only does the term "bull" refer to a type of investor, but it can describe an entire market trend. A bullish market is one where:
- -There's a prolonged period of rising stock prices
- -By at least 20% over at least two months or longer
- -There's a strong or strengthening economy
- -Investors are highly optimistic
- -Investors are highly confident
- -There's an expectation things will stay positive for a long time
But the market doesn't have to be bullish for bulls to seek fortune. They often look for growth within a down or bearish market. But before explaining bear markets, let's discuss bear investors.
Explaining Bears
Bears think that a particular security or the whole market is spiraling downward. They seek to profit from lowering stock prices. Bears are characterized by pessimism in a specified market or economy.
They expect prices to decline in the near or medium term and plan accordingly. Bears often use short selling to get ahead of a declining market.
Short selling is when investors borrow securities and sell them at market price. This is an investor taking a "short position."
They intend to repurchase them at lower prices due to the continuing market downturn. They expect that security prices will keep getting lower. Investors close their short positions by rebuying the securities.
Said securities are then returned to the lender or broker. Short selling profits come from the difference between the original security price and the price received when returning it to the lender.
Short selling doesn't work as well during a bullish market. So, how do you identify a bearish market? Key identifiers are:
- -A prolonged period of declining stock prices
- -By at least 20% over at least two months or longer
- -A weak or weakening economy
- -Investor optimism waining
- -Investor confidence waining
- -Unemployment rates rising
- -An expectation things will stay depressed for a long period
All this means is that bears and bulls use market sentiments to gauge how and where to make investments. They use sources like seasonal factors and economic reports as financial behavior indicators.
How Stock Market Emotions Can Backfire
Everything we've said so far may sound entirely within the realm of logic. Investor sentiment analysis does require gathering and reading market data.
However, bulls and bears rely a lot on what they feel will happen within the market. An issue with sources like national and global events and investor behavior is media hype and fearmongering.
Investors often buy securities only to lose money due to emotional investing. This is because they invest based only on fear or greed. That said, harnessing stock market emotions is still useful for investors.
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What Is Open Outcry?
We mentioned open outcry a while back in the article. To reiterate, open outcry was a popular method -- before 2010 -- to communicate orders in trading pits.
Orders within the stock market are instructions to brokers or brokerage firms. The brokers sell securities on an investor's behalf. The trading pit is a section of the trading floor where investors trade orders face-to-face.
The goal was to facilitate eye-to-eye contact. To that end, trading pits usually had tiered floors so you could look as many people in the eye as possible.
Open outcry gave everyone an equal chance to compete for orders. Traders all had the same opportunity for fair price discovery, or setting prices on trading assets. There was also plenty of market efficiency.
An efficient market is one where prices come from all relevant and available information. It's harder to beat the market or gain an advantage over other investors because there are no under or overvalued securities.
Everyone has access to accurate data. Open outcry was transparent with information and emotion. We said the process involved yelling orders and using hand signals to send information about orders.
The upfront physicality could help better gauge what investors are thinking. It's easier to gauge market volatility if people look on edge.
You can see everyone, hear them discuss, and know if it's time to slow down or buy more. All investors have the same information in front of them and can see how others react to said data.
Why Did Open Outcry Fall Out of Favor?
Open outcry eventually fell to the wayside in favor of electronic trading. Computers make order execution faster. Open outcry needs people to handle all aspects of trading.
Electronic systems also cost less money to maintain. It took plenty of funds to manage the upkeep of physical spaces. Computerized systems scale more easily and can handle a larger volume of orders.
Open outcry could even be distracting. Flashing screens and loud noises could cost investors their fortunes.
What Is the Fear and Greed Index?
Open outcry wasn't specifically developed to measure market sentiment. However, it helped do so. The Fear and Greed Index helps investors with investment sentiment analysis too, albeit more indirectly.
It was created by CNN Business in 2012 to give price information to investors. This market sentiment index gets its name from the logic that extreme fear lowers stock prices while greed increases prices.
The Fear and Greed gauge measures how much investor emotions influence what they pay for stocks. This, in turn, tells other investors whether stocks are over, under, or fairly priced at any given moment.
How Does the Fear and Greed Index Work?
The Fear and Greed Index is a hundred-point scale. Lower numbers indicate a more fearful, pessimistic bearish market. A higher number implies a more greedy, optimistic bullish market. Here's a rundown of the scale:
- Score 0 to 24: Sentiment - Extreme Fear
- Score 25 to 44: Sentiment - Fear
- Score 45 to 55: Sentiment - Neutral
- Score 56 to 75: Sentiment - Greed
- Score 76 to 100: Sentiment - Extreme Greed
The index uses more than the hundred-point scale. There are also seven stock market indicators. The first one is market momentum.
Market momentum measures how fast a security's price changes and if the broad price can sustain itself. It compares the S&P 500 to its' moving average over the past 125 days.
The S&P 500 or Standard & Poor's 500 Index lists the 500 leading publicly traded companies in the United States. Moving averages measure data from a series of different averages across various selections from a full set.
You subtract closing prices from current market prices to see how quickly prices change. Then you'd take averages from ten-day groups within a 125-day set to see how quickly or slowly people buy securities.
Positive momentum is when the Fear/Greed index value outweighs the 125-day average -- shifting the index toward greed. Negative momentum is when the Fear/Greed score is lower than the average -- pointing to fear.
Stock Price Strength
Stock price strength compares New York Stock Exchange stocks trading at 52-week highs vs. their 52-week lows. More highs imply investor greed, while more lows indicate a pessimistic bearish market.
Stock Price Breadth
The Fear and Greed Index measures the volume of trading too. It uses the McClellan Volume Summation Index, which shows trading volume on strong and weak days.
Rising volume may denote greed and a bullish market. Lowering trading volume signals investors are fearful of buying.
Put and Call Options
A put allows you to sell securities at later dates. Calls will let you purchase them later. The put/call ratio shows if investors largely expect to buy or sell in the future.
This part of the Fear and Greed Index measures the five-day put/call ratio. A value of "1" is neutral. Values greater than one may show fear, any value lower than one implies greediness.
Market Volatility
The Fear/Greed Index uses the 50-day moving average CBOE Volatility Index (VIX) to estimate market volatility. VIX tracks the relative strength of S&P 500 near-term price changes.
Rising averages show a fearful, bearish environment. A shrinking average can tell investors that others feel optimistic about the market.
Safe Haven Demand
Investors often increase bond exposure and reduce stock exposure. They put more money into their bonds, and lessen how much they put toward stocks.
The safe-haven demand measures this tendency by comparing precious 20-day returns of Treasury bonds vs. stocks. Higher stock demand shows investors are feeling greedy. Greater demand for bonds signifies caution.
Junk Bond Demand
The Fear and Greed gauge measures the demand for junk bonds by the yield spread between them and investment-grade bonds. The yield spread is the difference in the quoted return rates between two investments.
Smaller differences in yields often make investors more open to risk -- they tend to get greedy. A larger yield difference makes people cautious and more fearful.
Invest With Emotion; But Not Too Much
Gauging stock market emotions is vital to making smart, sound investments. Open outcry was once a popular way to do this, but the Fear and Greed Index became a kind of spiritual successor.
The latter provides accurate information without the distraction of loud trading pits. Regardless of how you invest, it's vital to remember not to get too emotionally involved.
No market sentiment index is perfect. That's why you should observe investor behaviors and sources. -- like news and financial reports -- alongside financial data points. Don't ever buy based solely on emotion.
Of course, we've got more investing advice than how to use the Fear and Greed Index. The US Gold Bureau has all the information you need to begin investing. Get a hold of our FREE precious metals investor guide and start today!
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byUnited States Gold Bureau