Sometimes, investment in the stock market can feel like a rollercoaster ride. While we go through a series of emotions every day, such as happiness, focus, or even frustration, the stock market has its moods too, which is driven by the collective behavior of its participants. This phenomenon is what we call market sentiment. Understanding it can help investors make more informed decisions when entering or exiting positions.
In this blog, we’ll explore what market sentiment is, how tools like the Fear and Greed Index and Market Mood Index (MMI) work, and how they can guide your investment strategy.
What is Market Sentiment?
Market sentiment is the general attitude of investors toward a particular market, sector, or stock at any point in time. It’s largely influenced by crowd psychology—that is, what the majority is thinking and feeling. While this may sound subjective, there are scientific methods and tools to measure it.
One of the most popular tools is CNN’s Fear and Greed Index, which assesses market sentiment through variables like market momentum, volatility, and options trading. The MMI, specific to India, also computes the mood based on data regarding economic indicators, corporate earnings, trade volumes, and even social media activity. These metrics help generate a single number representing the market’s mood.
Understanding the Market Mood Index (MMI)
The MMI, as available on Ticker Tape and other similar platforms, breaks down market sentiment into four bands:
Extreme Fear (0-30): It is a buying opportunity
Fear (30-50): Indicates cautionary sentiments
Greed (50-70): Shows optimism but calls for caution
Extreme Greed (70+): It warns that the market may be overheating and one should think of getting out or at least be cautious.
For instance, the date of this video is the time when MMI was standing at 73.3, which showed extreme greed in the participants of market.
How Market Sentiment Impacts Investment Decisions
Hypothesis is simple
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- Extreme Fear is very good time for buying; the stocks would be at low price because of market panic.
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- Extreme Greed means to watch out because of overprices.
But does this theoretical hold in practice?
Experiment 1: Investing in Extreme Fear vs. Extreme Greed
The hypothesis was tested by performing an analysis on historical MMI data for the last 12 years. It was done from two perspectives:
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- Making an investment when there is Extreme Fear (MMI < 30).
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- Investing when there is Extreme Greed (MMI > 70).
Surprisingly, the results showed little difference in performance between the two scenarios. On average, the Nifty rose by nearly 1% in the 10 sessions following an Extreme Fear phase. However, investing during Extreme Greed also delivered similar results over longer timeframes.
Experiment 2: Strategic SIP Investing
Next, the study simulated a systematic investment plan (SIP) with variations based on MMI bands:
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- Extreme Fear (MMI < 30): Multiply SIP amount by 2 (₹20,000).
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- Fear & Greed (30-70): Normal SIP amount (₹10,000).
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- Extreme Greed (MMI > 70): Stop the SIP (₹0).
Over 12 years, this strategy gave an XIRR return of 14.2% versus a regular SIP that provided a return of 14.1%. While the returns were close to being equal, the strategic SIP provided a marginally better usage of capital.
Experiment 3: Short-Term vs. Long-Term Investments
The third experiment compared the performance of entry points based on different MMI bands for various time periods—3 months, 1 year, and up to 5 years.
Main conclusions:
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- Short-term (3-12 months): Investing during Extreme Fear offered better returns and lower chances of losses. For instance, Extreme Fear had less than a 10% chance of negative returns within a year.
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- Long-term (5+ years): The difference in returns across MMI bands became negligible, emphasizing the importance of staying invested rather than timing the market.
This reinforces a crucial lesson: market sentiment matters more for short-term investments, while long-term returns depend on staying invested through market cycles.
Additional Tools for Market Sentiment Analysis
Market sentiment isn’t just about MMI or the Fear and Greed Index. Here are some additional tools that can help:
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- Momentum Indicators:
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- Relative Strength Index (RSI): Indicators of whether a stock or market is overbought (>70) or oversold (<30). – MACD and Stochastic Oscillators: Helps analyze the momentum and trend reversals of price. 2. Market Breadth Indicators: Tracks number of advancing vs. declining stocks and their trading volumes.
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- A low Arms Index (<1) is bullish, while a higher value (>1) is bearish.
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- Put-Call Ratio:
This tool analyzes options trading data to determine whether the market is bullish or bearish.
Each tool gives a different view, and combining them can provide a more complete view of market trends.
- Put-Call Ratio:
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- Short-term investors:
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- Apply MMI and RSI to get good entry and exit points.
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- The Extreme Fear condition gives high chances of positive returns in the short term.
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- Short-term investors:
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- Long-term investors:
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- Less emphasis on the sentiment and more emphasis on staying invested.
Over time, entry points become secondary in relevance as the natural growth of the market takes over.
- Less emphasis on the sentiment and more emphasis on staying invested.
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- Long-term investors:
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- Don’t Make it Too Complicated:
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- While market sentiment analysis is useful, wealth accumulation in the long run has its source in sticking to a disciplined investment plan.
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Market sentiment analysis can be a valuable tool for refining your investment strategy, especially in the short term. Tools like the Fear and Greed Index, MMI, and RSI help decode the market’s mood, offering insights into when to buy or sell.
Remember that with no tool or strategy ever comes a guarantee of winning. The nature of the stock market is very unstable, and discipline often overtakes the perfect entry and exit when investing. Whatever it may be – a short-term trader or a long-term investor, knowledge of market sentiment enables one to ride out better through the ebbs and flows of the stock market.