The Stock Market's Fear & Greed Index Just Shifted Toward Greed. History Says This Is What Happens Next for S&P 500 Investors.

Investor sentiment is rapidly shifting. One month ago, the market was extremely fearful. Now, the market is greedy.

That's according to CNN's Fear & Greed Index, a tool that has become a somewhat reliable way for investors to gauge sentiment and anticipate where the wind may start blowing next.

The Fear & Greed Index uses seven different indicators of financial markets to measure collective investor sentiment. The seven indicators are market momentum, stock price strength, put and call options, junk bond demand, market volatility, and safe haven demand. These metrics are all measured in different ways.

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For instance, stock price strength is measured by comparing equities on the New York Stock Exchange that hit one-year highs against those that hit one-year lows.

Safe-haven demand measures returns for equities against those of U.S. Treasury bonds. All of these metrics are monitored in real time and used to create an overall score ranging from 0 to 100.

Based on where the score falls, investor sentiment is assigned as follows:

• 0 to 24: Extreme Fear
• 25 to 44: Fear
• 45 to 55: Neutral
• 56 to 75: Greed
• 76 to 100: Extreme Greed

The score represents a live snapshot of how the market is collectively feeling, so when it's fearful, investors are more prone to sell stocks. If it's greedy, investors may be more prone to buy stocks. As of this writing, the index registered a 70, meaning it is in the upper tier of the greed range.

However, the sentiment can also be a precursor for what happens next. With the index recently flipping toward greed, history says this is what happens next for S&P 500 (SNPINDEX: ^GSPC) investors.

No need to panic, but start thinking more conservatively

The Fear & Greed index has historically shown a knack for predicting market turning points. For instance, the index soared past 80 in 2017, during a strong rally fueled by large tech stocks.

The market would have a tough year in 2018. It also fell below 10 during the COVID-19 Pandemic in 2020. The market went on a big run in late 2020 and 2021.

Essentially, an extreme fear reading can signal that a marketwide sell-off may be coming to an end, while an extreme greed reading can signal the opposite. Following an extreme fear reading, S&P 500 returns over the next three months have averaged 8.6% since 2019, according to an analysis by Nationwide Financial.

Now, clearly, this index can change quickly, especially during a time when there are daily headlines on the Iran war that can send the market blasting up or down on a dime.

The current reading of 70 suggests the market can keep rising in the near term, but that the bullish cycle may be winding down. Extreme fear and extreme greed readings have been better at predicting the ends of buying or selling cycles, so investors don't need to panic right now, but should continue to monitor the index.

Like many other data points that investors rely on, the CNN Fear & Greed Index is not a perfect indicator, and while history often rhymes, it rarely repeats itself.

S&P 500 investors certainly don't need to panic right now, but should be aware that the S&P 500 may be approaching a near-term peak, especially if the Fear & Greed index moves into the extreme greed zone.

Long-term investors don't need to do anything to their positions because the index reflects and foreshadows shorter-term trends and moves. Still, understanding this tool and monitoring it will keep investors more informed, calmer, and better positioned to make rational investment decisions.

Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.