Technical and fundamental analysis is important in researching stock opportunities, but market sentiment often overrides those metrics. Market sentiment reflects collective emotions investors express about a particular commodity, business sector, or market trends in general.
Sometimes, this sentiment is driven by news, earnings reports, overall economic conditions, or events. Just as often, though, it can spring from a crowd mentality or group-think reacting to questionable forces or disinformation.
Market sentiment can have an outsized effect on stock prices, driving them up or down due to factors that might not be under the issuing companies’ control. In this piece, Gorilla Trades takes a closer look at how market sentiment impacts investor psychology, as well as how you can interpret this sentiment and account for it when making investment decisions.
Defining Market Sentiment
Market sentiment refers to investors’ pervasive feelings regarding the stock market, certain commodities or sectors, and current and future economic conditions. It also refers to behavioral trends and decisions within the greater investor pool, like the purchase of meme stocks or mass exoduses from certain positions.
It’s important to note that market sentiment does not reflect a company’s financial fundamentals or technical traits. Some media sources have tried to harness market sentiment and represent it as a data point, as with CNN’s Fear & Greed Index. But it can be difficult, if not impossible, to turn qualitative reactions into quantitative data.
Even so, sentiment analysis can’t be entirely discouraged or discredited. It has to factor in at least somewhat to the overall assessment of the affected stocks and sectors. So how much should market sentiment influence investors’ decision-making?
How Market Sentiment Influences Investor Behavior
Market sentiment isn’t always wrong. Sometimes, there are very good reasons that justify why investors feel a certain way toward a commodity or business sector. However, market sentiment should never be interchangeable with rational analysis — it’s a feeling, and by definition, feelings are irrational, even if they’re understandable.
Nevertheless, sentiment works with an investor’s cognitive bias that could lead to suboptimal decisions. For example, an investor who’s enjoyed a recent string of positive trading results may become overconfident and take on excessively risky commodities. They may bypass traditional analysis or over-pursue certain stocks or sectors to make their portfolios less diversified.
Fear can be just as powerful as greed when it comes to behavioral finance. A sudden downturn or drastic price drop could cause panic in some investors, leading them to over-selling and exiting positions too quickly. That pessimism can snowball across the investment community, especially when it’s exacerbated by media sources seeking to generate headlines and viewership. In turn, market volatility heats up.
Behavioral investing often drives the development of a herd mentality. When certain investors see others jumping on a fad or meme stock, they may neglect reasonable research and buy into it for fear of missing out.
The opposite can also happen, as a mass retreat from a certain stock can trigger a premature withdrawal. Both of these tendencies can drive prices too high or too low, in defiance of companies’ fundamentals and technical indicators.
Researchers Daniel Kahneman and Amos Tversky gave this market sentiment a name: the Behavioral Financial Theory. It describes investors as “boundedly rational,” meaning there are limits to how much quantitative information they can process.
This is often the case when access to hard data is restricted or constrained, especially when time is a factor. When that’s the case, many investors make decisions based on oversimplified models or personal bias — neither of which is reliable.
How Market Sentiment Affects Share Prices
It’s relatively easy to see how widespread market sentiment can drive share prices higher or lower. When an earnings report shows positive results for a certain commodity, investors get excited, buy more shares, and drive its price upward — even if the company’s fundamentals are essentially the same.
General economic news and global events can also spur market sentiment. Low unemployment rates and GDP growth tend to generate feelings of hope, whereas recession threats can drive fear. Hope and fear are often the catalysts in creating stock market bubbles and sector crashes — the dot-com bust of the late 1990s is a stark reminder of that behavior.
Bullish vs. Bearish Sentiment
Market sentiment serves as a loose barometer of the general market outlook, whether optimistic, pessimistic, apathetic, or uncertain. When investors are optimistic about given stocks or the general market, sentiment is bullish. This usually results in higher trading volume and a rise in stock prices.
On the other hand, when the investor community is feeling pessimistic, the sentiment turns bearish. That increases the pressure to sell shares and drives prices and values lower.
Both extremes shape market trends and valuations. They also impact investor behavior. However, as indicators, they can fall short when it comes to reasonable and thorough analysis.
Once something is given a simplified name like “bull” or “bear,” it’s often the only description novice investors depend on to make choices. But there is usually more to the story.
What is interesting about bullish vs. bearish sentiment is that bull markets are generally less noticed than bear markets. When the market’s doing well, growing at reasonable rates, and building wealth over time, not many think to highlight their good fortune. But when a sudden shock to the market causes a massive panic or sell-off, generating media hype and attention, waves of fear start spreading and take all reason away.
Sentiment Analysis
Investment professionals have tried to assign measurable values to market sentiment. Some of their attempts are worthy. The American Association of Individual Investors (AAII) Sentiment Survey analyzes the current mental and emotional state of the market, which can be useful in tracking other investors’ behavior and gauging impact.
But even the AAII will tell you its findings should only be a fragment of investors’ research, if at all. They acknowledge their survey is a “contrarian indicator.” This means that it may suggest investors take action based on the opposite of their results.
For example, if they show investors souring on the stock market and lowering share prices, it may be a good time to enter into some positions because they might be due for a rebound. While this approach sometimes works, it’s not always timely or reliable, and it can backfire.
Other indicators tend to reflect investor sentiment. The put-call ratio compares trading volumes to measure enthusiasm, pessimism, or indifference over a given stock. The CBOE Volatility Index (VIX) — which some call the “fear gauge” — uses options prices on S&P 500 commodities to predict market volatility over the next 30 days.
While these sentimental indicators can provide insight, they shouldn’t serve as the sole nexus to investment decisions. Indeed, the AAII says that it’s best to stick to a long-term plan “based on sound fundamentals and data-driven techniques or strategies,” rather than using sentimental analysis alone.
Market Sentiment and Investment Strategy
In the end, market sentiment is impressionable. It’s simply a snapshot of mood and temperament, the driving influences of emotional trading — Gorilla Trades’ sworn enemy in making investment decisions. It can be fair to use market sentiment to get an idea of the context surrounding a stock or sector, but not to make a final choice.
Stay grounded in fundamentals and technical analyses: financial results, earnings growth or decline, and long-term prospects and valuation. Metrics like these are rooted in measurable reality, whereas the fleeting, ever-changing nature of market sentiment may not be reliable in the long term.
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