Investors are getting greedy again

The stock market is near an all-time high – despite a modest pullback on Monday.

November has been a stellar month for investors as optimism about a coronavirus vaccine and relief about the outcome of the presidential election have trumped renewed worries about another surge in Covid-19 cases. It seems safe to say that investors are feeling more greedy than fearful.

That’s registering on CNN Business’ index that tracks the market’s mood. The CNN Business Fear & Greed Index, which measures seven gauges of investor sentiment, is now in “Extreme Greed” territory.

The Fear & Greed Index works like this: Each of the seven indicators are equally weighted and measured compared to how they’ve performed recently.

The aggregate score of these weightings is then compiled into one Fear & Greed score ranging from 0 to 100, with lower numbers indicating fear and higher numbers signaling greed.

For context, the index fell to an annual low of 2 on March 12. That was the day that stocks plunged about 10% and entered a bear market after President Trump announced a US travel ban for much of Europe because of escalating coronavirus contagion fears.

It was the day after the NBA also announced it was suspending its basketball season because a player contracted the virus. It’s also the day after Tom Hanks and his wife Rita Wilson said they had tested positive. In other words, it’s when Covid-19 became real for most Americans. The World Health Organization also declared the coronavirus outbreak a pandemic on March 11.

But the Fear & Greed Index is now firmly in “Greed” territory as investors grow hopeful that a vaccine can help the economy return to normal. The index was in “Neutral” just last week – right before Pfizer (PFE) announced positive data for its vaccine.

The value of the index tends to rise and fall with the broader market. So times of intense fear have often coincided with near-term market bottoms, while high levels of greed can be an indication the market is overheating and that it’s a good time to sell some stocks.

Since the index’s inception in 2012, CNN Business has used it to help keep tabs on Wall Street sentiment and some investment firms have also cited the index in their research as a tool to track the market’s mood.

Here is a closer look at the seven indicators in the index and what they mean for average investors.

Market Volatility

The most well-known measure of market sentiment is the CBOE Volatility Index (VIX), or VIX. The VIX measures expected price fluctuations or volatility in the S&P 500 Index options over the next 30 days. The VIX often drops on days when the broader market rallies and soars when stocks plunge. But the key is to look at the VIX over time. It tends to be lower in bull markets and higher when the bears are in control. The F&G Index uses increasing market volatility as a signal for Fear.

Stock Options

Options are contracts that give investors the right to buy or sell stocks, indexes or other financial securities at an agreed-upon price and date. Puts are the option to sell while calls are the option to buy. When the ratio of puts to calls is rising, it is usually a sign investors are growing more nervous. A ratio above 1 is considered bearish. The F&G Index uses a bearish option as a signal for Fear.

Momentum

It’s useful to look at stock market levels compared to where they’ve been over the past few months. When the S&P 500 (SPX) is above its moving or rolling average of the prior 125 trading days, that’s a sign of positive momentum. But if the index is below this average, it shows investors are getting skittish. The F&G Index uses slowing momentum as a signal for Fear and growing momentum for Greed.

Junk bond demand

Junk bonds carry a higher risk of default compared to other bonds. Bond yields – or the return you get on investing in a bond – dip when prices go up. If investors crave junk bonds, the yields drop. Likewise, yields rise when people are selling. So a smaller difference (or spread) between yields for junk bonds and safer government bonds is a sign investors are taking on more risk. A wider spread shows more caution. The F&G Index uses junk bond demand as a signal for Greed.

Trading Volume

The market is made up of thousands of stocks. And on any given day, investors are actively buying and selling them. This measure looks at the amount, or volume, of shares on the NYSE that are rising compared to the number of shares that are falling. A low (or even negative) number is a bearish sign. The F&G Index uses decreasing trading volume as a signal for Fear.

Safe Haven Demand

Stocks are riskier than bonds. But the reward for investing in stocks over the long haul is greater. Still, bonds can outperform stocks over short periods. Safe Haven Demand shows the difference between Treasury bond and stock returns over the past 20 trading days. Bonds do better when investors are scared. The F&G Index uses increasing safe haven demand as a signal for Fear.

Highs vs. Lows

A few big stocks can skew returns for the market. It’s important to also know how many stocks are doing well versus those that are struggling. This shows the number of stocks on the NYSE at 52-week highs compared to those at 52-week lows. When there are many more highs than lows, that’s a bullish sign and signals Greed.