If there’s one insight into financial markets that I’ve gained after more than 25 years of experience, it’s this: Stock markets are governed by market sentiment.
The study of market sentiment may get little respect from academics and Wall Street traders.
Yet the market is driven by little else.
Knowing investor psychology and financial history will get you a lot further in stock market investing than, say, mastering the Nobel Prize-winning capital asset pricing model.
History Rhymes, Once Again
As Yogi Berra quipped, “It’s tough to make predictions, especially about the future.”
Yet certain patterns recur that give experienced investors an edge.
The details of any market correction will always differ. Yet the story arc of each correction remains remarkably consistent.
Today’s market headlines are dominated by Russia’s invasion of Ukraine.
Yes, this is the greatest military, political and refugee crisis in Europe since World War II. Russia’s Vladimir Putin has even rattled Russia’s nuclear saber.
That said, when COVID-19 struck two years ago, it was equally – if not more – ominous. Remember, there were no vaccines at the time. And for all we knew, the world was facing a new “Black Death,” which killed almost one-third of Europe’s population after its arrival in 1347.
On March 19, 2020, I wrote a fictional “look back” piece on how investors would be feeling in 2022.
It’s worth repeating here:
The year is 2022. And you are sitting on a “bloody fortune.”
After a turbulent year in 2020 – even as investors around the world were losing their heads – you kept your cool.
You understood that the market sell-off in March 2020 was a gift from the market gods.
In time, COVID-19 came and went. The final death toll was a far cry from the Spanish flu of 1918 with its 50 million victims.
The U.S. stock market had fallen through the floor in March, wiping out five years of gains in five weeks. Warren Buffett’s Berkshire Hathaway (NYSE: BRK-B) suffered a 50% drawdown for the fourth time in its 54-year history.
Market hysteria in the U.S. peaked in April. Slowly but surely, the panic abated as the growth in the number of cases slowed.
By June, U.S. stocks had steadied. Global financial markets embarked on a ferocious bull run. And you were well on your way to making a “bloody fortune”…
You didn’t just turn lemons into lemonade. You turned lemons into a bottle of Dom Pérignon.
At the time, I emphasized two lessons…
First, understanding investor psychology was the key to recognizing – and profiting from – the market sell-off.
My advice was not to panic. Instead, it was to “keep calm and carry on.”
Remember, financial markets are driven by fear and greed. So the bigger the panic, the bigger the bounce.
Second, refresh your knowledge of financial history.
Read about famous historical financial panics in Edward Chancellor’s Devil Take the Hindmost: A History of Financial Speculation.
Use the lessons learned from other panics in your life as well – the dot-com bust of 2000, the global financial crisis of 2008 and the COVID-19 crash of 2020.
Remind yourself there’s never been a correction that did not end.
Quantifying Market Sentiment
For many years, measuring investor sentiment was a matter of simply doing the opposite of what the headlines told you. And I believe that is still a good start.
Today, my favorite “quick and dirty” measure of investor sentiment is CNN’s Fear & Greed Index.
A composite of seven underlying indicators, the Fear & Greed Index provides 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?
All seven indicators are in bearish territory, six of them in “extreme fear.” The overall index stands at 16.
Investing in the stock market during times of extreme fear is challenging.
Often, it feels just plain wrong.
Here’s what hard-won experience has taught me: The worse an investment feels when you make it, the more likely it is to become profitable.
Combine your knowledge of market history, investment psychology and the Fear & Greed Index, and you come to one conclusion.
Today’s market is a screaming “Buy.”
Click here to watch Nicholas’ latest video update.