Market Overvaluation and Correction Risks: A Sentiment-Driven Analysis

Investor sentiment has long been a double-edged sword in financial markets. While optimism drives growth, excessive euphoria often precedes corrections. As of October 2025, data from the AAII Investor Sentiment Survey reveals a surge in bullish sentiment to 41.7%, surpassing its historical average of 37.5%. This suggests a cautiously optimistic outlook among individual investors, yet it raises questions about whether markets are nearing overvaluation.

The CNN Fear & Greed Index, which aggregates seven indicators-including the CBOE VIX and the S&P 500's momentum-provides further context. By October 2025, the index averaged 47.08, a marked decline from its 2024 peak of 78 and a stark contrast to the extreme greed (78–100) observed in 2024. This shift reflects a broader recalibration of risk tolerance, driven by macroeconomic uncertainties such as inflationary pressures and central bank policy tightening. However, the index's volatility underscores the fragility of current sentiment. For instance, its plunge to 3 in early 2025-a level of "extreme fear"-demonstrates how rapidly investor psychology can pivot under stress.

Historical precedents reinforce the predictive power of sentiment indicators. In 2021, the Fear & Greed Index frequently exceeded 90, signaling euphoric overconfidence. This was followed by a 30% correction in 2022, triggered by the Federal Reserve's aggressive rate hikes and geopolitical shocks like the Russia-Ukraine war. Today, while the index remains below its 2021 highs, its current trajectory-fluctuating between caution and optimism-suggests a market in flux. The S&P 500's performance relative to its 125-day moving average, a component of the Fear & Greed Index, further complicates the picture. A sustained above-average reading could indicate bullish momentum, but it also risks inflating asset prices beyond fundamental justifications.

Behavioral finance literature adds nuance to this analysis. Research on investor sentiment and economic policy uncertainty, including a study in Economic Modelling, highlights how behavioral biases-such as overreaction to news or herd behavior-amplify market swings. For example, the collapse of Silicon Valley Bank in March 2023 and the Fed's rapid rate hikes created a feedback loop of fear and risk aversion, distorting asset valuations. Advanced econometric models, including QVAR and WLMC, confirm that sentiment shocks have asymmetric effects on financial markets, often leading to sharp corrections when optimism turns to panic.

The VIX, or "fear gauge," remains a critical barometer. While recent data does not specify its exact level, the index's inclusion in the Fear & Greed framework underscores its role in measuring volatility expectations. A rising VIX typically signals investor anxiety, which could materialize if inflation resists central bank efforts or if global growth slows unexpectedly.

For investors, the takeaway is clear: current sentiment indicators suggest a market balancing optimism with caution, but structural risks persist. The historical correlation between extreme greed and subsequent corrections implies that even moderate overvaluation could trigger a pullback if sentiment shifts again. As behavioral finance research emphasizes, markets are not purely rational systems; they are shaped by human psychology, which can amplify both gains and losses.

In this environment, a disciplined approach to risk management is essential. Diversification, hedging against volatility (e.g., via VIX-linked instruments), and a focus on fundamentals-such as earnings growth and valuation metrics-can help mitigate overvaluation risks. While the current Fear & Greed Index reading of 47.08 does not yet signal extreme overconfidence, it serves as a reminder that markets are never static. As the Fed's policy trajectory and global macroeconomic trends evolve, investor sentiment will remain a pivotal, and often unpredictable, force.