The term market sentiment, also known as investor sentiment, refers to the general outlook or attitude of investors toward a particular security or the overall financial market. The optimism or pessimism of the market players is most evident in the overall price trends.
The term market sentiment, also known as investor sentiment, refers to the general outlook or attitude of investors toward a particular security or the overall financial market.
The Behavioural Theory of Finance by Kahneman and Tversky and the Animal Spirit Theory by Keynes show how sentiment drives demand and supply.
Indicators such as the VIX, High-Low Index, Bullish Percentage Index, and Moving Average are used to measure market sentiment.
How Does Market Sentiment Affect Prices?
Sentiment drives demand and supply, which in turn leads to price movements. Market sentiment is bullish when prices are rising, whereas it is bearish when prices are falling. Traders combine market sentiment indicators with trading frameworks or other forms of analysis in order to refine entry and exit signals. The key to getting maximum returns is for an investor to gauge the mood correctly and act on it faster.
1. The Behavioral Financial Theory
The Behavioral Financial Theory, laid by Kahneman & Tversky, demonstrates various forms of psychologically-grounded investor “irrationality.” There is increasing evidence that suggests that investors are boundedly rational, and their decisions are often not in reference to fundamental rules but are guided by their own world perceptions or other investors’ decisions.
Investors’ cognitive and emotional biases – such as overconfidence in their ability to forecast, using the rule of thumbs in investment allocation, having difficulty adjusting their views to new information, excessive reliance on past performance – play a huge in determining the behavior of investors in the market place, more often leading to biased investing decisions.
2. The Animal Spirit Theory
The Animal Spirit Theory by John Maynard Keynes assumed such cognitive biases where under uncertainty, individuals are dominated by their instinct, and their actions are dictated by their sentiment. When the market is surging, investors will flock to it, expecting ever more unrealistic gains and allocating their portfolios accordingly.
When the inevitable downturn follows, investors will turn increasingly pessimistic yet surprisingly hold on to their risky portfolios to avoid capitalizing losses. Herd behavior is thus inevitably linked to market sentiment and may allow for irrational enthusiasm, which is often manifested in the form of inefficient prices and bubbles.
Trading Strategies Based on Market Sentiment
The most common reading of market sentiments is trading in tandem with prevailing market sentiments, which is an effective strategy for long-term investors. When market sentiment is bullish, prices of securities, such as equity, are expected to rise, resulting in capital gains and a steady dividend income in the future. It is commonly known as herd behavior and results in the formation of bubbles due to the free-rider effect.
However, herd instinct doesn’t always make for a good investment strategy. There are also investors who trade against prevailing market sentiments. In times of extreme pessimism, they look for beaten-down stocks, which come with strong fundamentals and offer immense growth potential in the future but are available at a bargain price.
Similarly, value investors believe that short-term price movements are not a good enough description of the fundamental performance of a company. It is because markets tend to momentarily overreact to good news or bad news. Value investors look for stocks that are currently undervalued with respect to the intrinsic value of that company.
Indicators used to Measure Market Sentiment
The VIX, or the Fear Index, is an indicator of a need for insurance in the market. During times of increased volatility, the VIX increases as a sign of increased risk.
2. High-Low Index
The High-Low Index is a comparison of the number of stocks that make up 52-week highs as opposed to the number of stocks making 52-week lows. When the index is high, it is considered to be an indicator of bullish market sentiment and vice versa.
The high-low indicator is applied to specific stock market indices, such as the S&P 500 and NYSE Composite.
3. Bullish Percent Index (BPI)
The Bullish Percent Index measures the total number of stocks in a given index that displays bullish patterns over a given period of time. If the BPI is high, around 80% or more, it signifies that market sentiment is optimistic. If the BPI is 20% or lower, market sentiment is considered to be negative.
4. Moving Averages
The simple moving average gives the overall price movement of a given security or stock index over a particular period of time. A 50-day or 200-day simple moving average is a common indicator or market sentiment.
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: