Investors are driven by two emotions: fear and greed. Too much fear can sink stocks well below where they should be. When investors get greedy, they can bid up stock prices way too far.
So what emotion is driving the market now? CNNMoney’s Fear & Greed index makes it clear. It looks at 7 indicators:
•Stock Price Momentum: The S&P 500 ( ) versus its 125-day moving average
•Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
•Stock Price Breadth: The volume of shares trading in stocks on the rise versus those declining.
•Put and Call Options: The put/call ratio, which compares the trading volume of bullish call options relative to the trading volume of bearish put options
•Junk Bond Demand: The spread between yields on investment grade bonds and junk bonds
•Market Volatility: The VIX ( ), which measures volatility
•Safe Haven Demand: The difference in returns for stocks versus Treasuries
For each indicator, CNN looks at how far they’ve veered from their average relative to how far they normally veer. They look at each on a scale from 0 – 100. The higher the reading, the greedier investors are being, and 50 is neutral.
Then they put all the indicators together – equally weighted – for a final index reading.
When the S&P 500 () plummeted to a three-year low on Sept. 17, 2008 – the height of the financial crisis — the Fear and Greed index sank to 12. The index gained some ground to 28 before stocks finally bottomed out on March 9, 2009 and the latest bull market began.
Most recently, in the first quarter of 2012, stocks staged their best run in decades, and the index showed pure greed.
Yesterday’s reading of “3” suggests an exaggerated level of fear. Whether it also marked some kind of bottom of the recent correction remains to be seen, but in any case it should signal a rebound, at least short-term.
This rhymes well with a comment by legend and billionaire Warren Buffett who told CNBC yesterday that he bought stocks in Wednesday’s big selloff (http://finance.yahoo.com/news/buffett-bought-stocks-wednesdays-big-134631323.html). Buffett said he likes to buy stocks when they go down, not when they go up. “The more [the market] goes down, the more I Iike to buy.” He added that trying to time the market by buying and selling individual names often is a “fool’s game.”