Definition: Market sentiment is the overall attitude that investors have towards a particular security or market, such as the stock market, foreign exchange market, or commodities market. Market sentiment can be an indicator of the future price movement of a particular security for investors.
How does market sentiment work?
Market sentiment is often supported by trend lines on price charts rather than the fundamental facts about the security or asset or market.
Many things can influence how people feel about the market or security. These can be as simple as a rumor or a circulating news headline, or as significant as an earnings release, economic update, or foreign relations with another country that affect people’s feelings about the market.
Market sentiment becomes more important to learn about as investment rises, supported by social media trends or meme stocks.
Example of market sentiment
For example, the excitement about technology and innovation led investors to become optimistic about tech stocks in the late 1990s. This drove the growth of many technology startups, many of which had successful IPOs and inflated valuations, popularly known as the dot-com bubble. However, this positive market sentiment was not necessarily supported strongly by the company’s fundamentals, eventually leading to the market crash in 1999-2000.
Types of market sentiment
Investor sentiment can be classified into three categories based on price expectations:
- Positive: Investor sentiment is considered positive when they expect the stock market or the price of the security to rise.
- Negative: Investor sentiment is considered negative when they expect the stock market or the price of the security to fall.
- Neutral: Investor sentiment is considered neutral when they expect the stock market or the price of the security to neither rise nor fall significantly.
Market sentiment indicators
Market sentiment is often measured by technical indicators that act as predictors of the future price movement of the security or market. Some common technical indicators used to measure market sentiment include:
- VIX Index: The VIX measures the expected volatility of the U.S. stock market by assessing the prices of options on the S&P 500 index.
- Moving averages: These are a series of averages plotted on a chart compared to the current price of the security. They are “moving” because the average changes day by day depending on the current price of the security. For example, if an investor takes the 50-day moving average for a security and the current price is below the 50-day moving average, it can be inferred that the current market sentiment is negative.
- Trading volume: This is the number of shares traded in a particular security and can be a great indicator of how investors feel about the underlying security. High selling volume may indicate negative sentiment. Conversely, a large number of purchases may indicate positive sentiment.
- Advance/Decline Index: This indicator measures the strength or weakness of a particular index by dividing the total of new highs by the total of new highs and lows over a specific time period. Values above 70 may indicate an upward trend, while values below 30 indicate a downward trend.
There are other ways to measure market sentiment through surveys such as the American Association of Individual Investors (AAII) sentiment survey. The AAII survey is sent to individual investors, asking them to express their opinions about the direction of the stock market in the next six months. This survey has been sent weekly since 1987; it is considered a great indicator of the general sentiment of investors towards the stock market.
Sentiment
Market Sentiment vs. Fundamental Analysis
Market sentiment and fundamental analysis are two ways for investors to better understand the pulse of the market, but they are very different approaches to recognizing market trends.
| Market Sentiment | Fundamental Analysis |
|---|---|
| Analyzes market indicators and trend lines to determine future price movement | Analyzes the underlying market or investment’s real data to determine intrinsic value |
| Based on the overall sentiment of investors towards the security or underlying market | Based on the actual performance indicators of the security or underlying market |
What Does This Mean for Individual Investors?
Market sentiment is a great way to provide context to your investment research. Understanding market sentiment can help investors make investment decisions that align with their goals.
Moreover, market sentiment does not always rely on the fundamental facts of the market or company and does not always indicate the future movement of the investment or market price. For example, in April 2020, the market experienced significant losses, yet investor expectations did not decline as expected. Despite the losses, investors continued to invest in anticipation of a positive market turnaround. Therefore, one should not rely solely on market sentiment as the basis for making an investment decision.
Frequently Asked Questions
Is market sentiment a good indicator?
Market sentiment reflects how investors feel about the direction the market is taking. Market sentiment does not always align with the fundamental metrics of the investment or market. This means there may be times when the market does not move according to investor expectations. It’s always best to consider multiple factors before making an investment decision.
How do you read market sentiment?
There are three types of market sentiment: positive, negative, and neutral. Investors are positive when they expect the market to rise, negative when they expect it to fall, and neutral when they expect no significant rise or fall in the market. You can gain insight into market sentiment using indicators such as the VIX index, moving averages, trading volume, and the highs and lows indicator.
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Sources:
CBOE. “CBOE VIX Index.”
American Association on Individual Investors. “The AAII Investors Sentiment Survey.”
Fidelity Investments. “Analyzing Stock Fundamentals.”
Amy (Chun-Chia) Chang, Shaokun (Carol) Yu, Alan Reinstein, and Natalie Tatiana Churyk. “An Overview Of Investor Sentiment in the Stock Market.”
Source: https://www.thebalancemoney.com/what-is-market-sentiment-6665702
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