It’s official: extreme greed is driving the stock market

In Is the VIX and indication of fear and complacency? I pointed out a few reasons I believe a low VIX level can indeed be a signal of greed and complacency and a high VIX level is a measure of fear. It’s very simple: fear and greed are reflected in the price of options. When there is a strong demand for protection, the prices goes up. When there is little demand for protection, the price goes down. The recent low levels of VIX suggest a lack of fear or desire for protection from falling prices or rising vol.

I also said that the VIX levels often correspond with other sentiment levels. I have used the Fear and Greed Index before to explain how investors oscillate between the fear of missing out and the fear of losing money. After prices rise, we observe they get more greedy. For example, if they didn’t have strong exposure they may feel regret and fear missing out. After prices fall, they are afraid of losing more money. This Fear and Greed Index is published by CNN Money and is publicly available, making it useful for this purpose to illustrate how behavior drives trends. As you can see below, the current level is “Extreme Greed”, so that is the emotion driving stocks right now.

Greed index correlates with low vix

Source: CNNMoney’s Fear & Greed index

This Fear and Greed Index includes 7 different sentiment indicators. Market volatility as measured by VIX is one of them. In observing sentiment indicators like this, we see them oscillating between extreme greed and extreme fear over time. It spends a lot of time in the middle, too, but trends often reverse when it gets to extremes. When it reaches Extreme Greed, it eventually reverses down after prices peak out and reverse down. When it gets to an extreme greed level like it is now, we eventually see something come along and surprise them. I think it’s because investors become complacent and the stunned. Change is most alarming when it isn’t expected. When stocks fall, it will move toward fear as they fear losing more money. However, these measures can certainly stay extreme for longer than you think. That is the challenge to countertrend systems and thinking: trends do tend to persist, making it more difficult to bet against the wind. But when we see levels like this, we shouldn’t be so surprised when it changes direction.

 

 

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