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How the Market Works

Greed

Posted by kdadmin on February 18th, 2015.

Greed is one of the seven deadly sins for a reason. And nothing, in the investment world, really underscores that reason better than CNN’s Fear & Greed Index. While I love this metric because it’s so sensationalized. There are three things you can learn from it:

  1. A good summary of a few useful, albeit volatile, bits of market sentiment information.
  2. An explanation of why these bits of information are relevant and how they work together.
  3. With a contrarian attitude, how you can avoid the deadly herd mentality.

If you recall my blog post in mid October, the market was in the midst of a crazy correction because of Ebola, QE ending AND earnings season. The Fear & Greed Index had a reading of 1. ONE. This meant everyone was terrified. So, what do amateurs do in these situations? They freeze up. They stop buying. They sell at the bottom out of fear. BECAUSE they don’t understand macro economics and/or what really drives the prices of the broad market. In other words, they don’t see what professionals see … a HUGE opportunity.

When the market tanks, for no reason other that short term news, and has been sustained at much higher levels, and is on solid macroeconomic footing, there is not reason to sell. In fact, there is every reason to buy, broadly speaking. At least there WAS back then.

Fast forward to today, we’ve seen a host of market gyrations and volatility all over the board. The year ended with the S&P 500 at 2060. January, 2015 watched dropped down to 1970 and then in February, it shot back up over 2100. Just yesterday, actually, though its uptrend is slowing. And where is the Fear & Greed Index? It’s at 77! SEVENTY-SEVEN. Just two weeks ago, it was at 24. When the S&P 500 was just above 2000.

So, what does this tell you? Well, I read this as the strongest DON’T BUY message I’ve seen in awhile. If you want to make money in the market, consistently, you can’t follow the herd. Amateurs (the herd) buy when the market is high, and sell when the market is low, because they trade on emotion. Professionals do the opposite. They buy during fear & sell during greed.

Consider the following charts of SPY (an ETF that tracks the S&P500) over the past three and the past six months. Then look at the Fear & Greed Index over the past three years. The section in the red box is roughly from early October to the present. What do you notice? Right, SPY & the Fear & Greed Index tend to move in tandem, with maybe a little lead or a little follow by the Fear & Greed Index. So, if these two move relatively in tandem, and they are both on the extreme high of their recent trends, then now, specifically, is probably not the time to buy the broad market.

Spy 3 Months

Spy 6 Months

FGI

One last thing, do you notice how the fear and greed index tends to run in spikes? It’s like the market sentiment is only capable of expressing itself as a bipolar roller coaster. So the further it trends toward one or the other of the extreme expression, the more likely it is that it will return to the other extreme. The further out it gets, the more vicious this whipsaw is likely to be.

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