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Doing the opposite of the crowd can pay dividends when you’re an investor.

Warren Buffett might have put it best. Investors need to “be fearful when others are greedy and to be greedy only when others are fearful.”

That was the case during the early April lows in the stock market. By some measures, pessimism and fear were running at historic levels.

Extreme investor fear helped trigger the bottom and then the relief rally that has unfolded.

But just as bearish views prevailed, the mood quickly changed.

So today, let’s look at how we can use extreme sentiment to spot key changes in the trend… and what it says could happen next in the stock market…

Extreme Fear Helped Spark the Rally

There are several ways to measure investor sentiment.

Some metrics are survey-based. You ask investors if they’re bullish or bearish on the stock market outlook. The AAII Investor Sentiment Survey asks investors where the market is heading over the next six months.

Back on April 3, the percentage of respondents with bearish views hit the third-highest level ever. You can see that in the chart below.

Bearish views stayed over 50% for 11 consecutive weeks. That’s the longest stretch ever.

Other sentiment measures look at how investors are positioning their portfolios. For example, we can look at the ratio of put options that investors purchase relative to call options.

Put options gain in value when a stock price declines, while call options gain in value when a stock price increases.

A spike in put option volume can point to excessive bearishness. The put/call volume ratio hit just over 1.0 back on April 3. That shows more volume in puts than calls… and was the highest level in nearly a year.

CNN’s Fear & Greed Index is another useful measure. It combines seven indicators of fear and greed: market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand.

It hit a level associated with “extreme fear” in early April.

Altogether, this excessive bearishness helped stocks find a bottom and spark a rally in early April.

But now the sentiment pendulum is swinging too far in the other direction.

Here’s why a spike in bullish moods suggests the rally could run out of fuel…

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The Pendulum Swings the Other Way

Following excessive levels of investor fear, bullish moods are prevailing once again.

The put/call ratio recently fell to 0.41. That’s the lowest level since January and is one of the lowest readings in two years. That shows investors are betting heavily on the rally.

The AAII sentiment measure showed bearish views dropping below 50% for the first time since the S&P 500 was near its all-time high.

And CNN’s Fear and Greed Index is now registering a “greed” reading… just a hair below “extreme greed.”

Collectively, investor greed has taken over.

That’s a quick shift since last month and shows investors have plowed back into the stock market.

But that’s a sign that the trend may have swung too far for now. And we shouldn’t fall prey to the “fear of missing out” that can trip up investors in these moments.

As Buffett suggested, now’s the time to be fearful once again.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict

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