“Be fearful when others are greedy and greedy when others are fearful.”
– Warren Buffett
2021 has been a terrific year for the U.S. stock market.
All the major U.S. indexes are up between 10% and 13% thus far. All are within spitting distance of their all-time highs.
And yet, as recent sell-offs confirm, investors are nervous.
Worries about the delta variant of COVID-19 are growing. Consumer confidence declined in July. Inflation is rearing its ugly head.
Here’s the irony… All of today’s negative headlines mean this may be the ideal time to invest in the stock market.
It all comes down to my favorite contrarian indicator: market sentiment.
Let me explain why market sentiment matters…
Investor sentiment has always driven markets. Yet Wall Street looks down on it as an instrument of market timing.
Investing based on sentiment seems simplistic compared with financial statement analysis or algorithmic trading.
But that’s ironic because the world’s best investors don’t just use market sentiment to make investment decisions… Many believe it’s the most crucial factor behind their success.
Buffett’s Secret Weapon
Warren Buffett is a disciple of value investing legend Benjamin Graham. This puts Buffett firmly in the camp of fundamental analysis.
But when asked what the single most important lesson Graham had taught him was, Buffett cited the concept of “Mr. Market.”
In The Intelligent Investor: The Definitive Book on Value Investing, Graham compared the market to a manic-depressive person.
Some days, Mr. Market is euphoric. Other days, he’s despondent. If you catch him on a euphoric day, he wants a very high price for his shares. If he’s in one of his down moods, he’s willing to sell you his shares for a pittance.
Mr. Market highlights the only thing you can predict about financial markets: Investors will always overreact to events, whether positive or negative.
Putting a Number on Mr. Market’s Mood Swings
For many years, it was impossible to quantify Mr. Market’s mood swings. But today, there are many ways.
One of my favorite websites, SentimenTrader, generates a handful of customized sentiment indicators every day.
But if you are looking for a “quick and dirty” solution, I recommend CNN’s Fear & Greed Index.
A composite of seven underlying indicators, the Fear & Greed Index provides a quick overview of market sentiment, giving you reliable insight into Mr. Market’s current mood.
You read the Fear & Greed Index much as you would a speedometer.
If the indicator rises above 75, it signals “extreme greed.” If it falls below 25, it signals “extreme fear.”
I have been tracking the indicator for about a decade. Over that time, it has fallen below 20 an average of about twice per calendar year.
I have seen it drop to zero on half a dozen occasions, most recently at the bottom of the coronavirus crash in March 2020.
But here’s the most critical thing… In every instance that I can recall, “extreme fear” turned out to be a terrific time to buy stocks.
So where does the Fear & Greed Index stand today?
Four of the seven indicators are in bearish territory, and the overall index standing is 17. The U.S. stock market is showing signs of extreme fear.
Because market sentiment is a contrarian indicator, today’s negative market sentiment makes now a perfect time to invest.
How I Use Market Sentiment in My Investing
Let me share my personal rule of thumb…
I have a set of core holdings – I call them my “never sell” portfolio. I will increase my investments in these stocks when the Fear & Greed Index drops below 20.
Right now, the Fear & Greed Index tells me that we are experiencing just such an opportunity.
Investing in the stock market during times of extreme fear is challenging. It often feels just plain wrong.
Still, here’s what hard-won experience has taught me: By betting against Mr. Market’s mood swings, I’m doing the right (and profitable) thing.
The Fear & Greed Index can help you do just that.