Investors are in an exuberant mood.
Financial pundits are hailing the “everything rally” in financial assets of all shapes and sizes.
Famed hedge fund investor Paul Tudor Jones sees a massive boom like “we’ve never seen before in history.”
Short sellers like Jim Chanos are throwing in the towel on bubble stocks like Tesla (Nasdaq: TSLA).
Meanwhile, analysts struggle to shoehorn sky-high valuations into plausible financial models.
Here’s the reality.
Conventionally trained financial analysts don’t have the analytical tools to explain current stock market valuations.
Yet, for students of history, today’s financial markets differ little from markets of the past.
They know that financial markets are not driven by homo economicus – the perfectly rational actor you find in finance textbooks.
Instead, markets are driven by fear and greed – by the ever-repeating cycle of boom and bust.
But to understand that, you don’t need an MBA.
How to Use Market Sentiment in Investing
Compared with numbers on spreadsheets, market sentiment seems to be a fuzzy concept.
J.P. Morgan famously recognized that the market was near the top in October 1929 when even his shoeshine boy was buying stocks.
But how do you quantify these insights?
As it turns out, there are many ways to measure market sentiment.
I recommend using a quick and dirty (and free) summary provided by the CNN Fear & Greed Index. (I look at the Fear & Greed Index every day.)
This useful indicator provides a quick overview of market sentiment by incorporating seven different sentiment indicators, including measures of momentum, breadth and the put-call ratio for options.
Investor sentiment ebbs and flows throughout a trading year.
But as a general rule, the Fear & Greed Index tends to reach extremes about twice a year.
As you can see from the chart below, the index registered “extreme fear” at the time of the market crash following the first coronavirus lockdowns.
Where does it stand today?
After the market close on December 4, it rated the market as being in “extreme greed” mode.
Here’s how I use the indicator in my investing.
Once the indicator enters “extreme greed” – say, about 80 or above – I rarely buy any stock.
Once the indicator gets above 90 (as it did early last week), the market invariably endures a sharp sell-off.
I get ahead of this looming pullback by putting on bearish positions to profit from it.
If the indicator falls below 20, then I do the opposite. I start looking at adding to positions.
That is precisely what I did after the “corona crash” in March 2020.
Since I have been tracking the Fear & Greed indicator, I have seen it drop to zero on half a dozen occasions.
In every instance I can recall, this extreme turned out to be a terrific time to buy.
What to Buy in a Market Pullback
The suddenness of market pullbacks after periods of euphoria always takes the average investor by surprise.
In contrast, savvy investors know these sharp market drops are inevitable. And they position themselves to profit from them.
The good news is you can do the same through inverse exchange-traded funds (ETFs).
Inverse ETFs bet against the market. That means they go up when the market goes down.
Say you’re convinced tech shares are due for a pullback over the coming month.
There are several ways you can profit from such a move.
You can bet against the Nasdaq-100 by buying the ProShares Short QQQ ETF (NYSE: PSQ). If the index drops 10%, this ETF will rise by the same amount.
There are even leveraged versions of this short bet.
Invest in the ProShares UltraShort QQQ ETF (NYSE: QID), and when the Nasdaq-100 drops 10%, the fund will jump around 20%.
Finally, the ProShares UltraPro Short QQQ ETF (Nasdaq: SQQQ) offers triple-short exposure. A 10% tumble in the Nasdaq-100 could generate up to 30% returns.
The bottom line?
The Fear & Greed Index’s reading makes today one of those “twice per year” opportunities where you can profit from extremes in market sentiment.
Inverse ETFs offer you the chance to do just that.