When researching a particular stock, we put significant effort into analysis, utilizing technical analysis for short-term positions and fundamental analysis for long-term holdings. Despite extensive research, we might still observe stocks surging or dropping without any apparent reason or structural impact, which can often be attributed to investors’ emotions.
Market sentiment refers to the collective attitude of investors towards specific securities or the overall market. It plays a crucial role in the ever-changing landscape of financial markets, helping us understand investors’ collective moods and psychology when making informed investment/trading decisions. By understanding different market sentiment indicators, we can gain valuable insights into potential market movements and get a glimpse into the collective psyche of market participants.
How market sentiment indicators can help
Market sentiment indicators can be highly beneficial to investors if used appropriately, offering valuable insights into market dynamics and potential trading opportunities. First, they help investors identify market trends by revealing whether investors are bullish (optimistic) or bearish (pessimistic) about a particular stock or the overall market.
Second, these indicators assist traders in identifying ‘optimal’ entry and exit points; extreme levels of bullishness or bearishness can signal that the market is overbought or oversold, thus indicating potential turning points in prices.
Third, when combined with fundamental or technical analysis, sentiment indicators can provide additional confirmation of a trend’s strength. Finally, investors who incorporate sentiment indicators into their strategies can better adjust their positions, potentially reducing their risk exposure.
Market sentiment indicators
After hearing so many benefits of market sentiment indicators, here are some of them:
- CBOE Volatility Index (VIX): The VIX, commonly known as the ‘fear index’, is a real-time index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500 Index. Its value is derived from the prices of S&P 500 index options with near-term expiration dates, generating a 30-day forward projection of volatility. The VIX generally has an inverse relationship with the S&P 500. A high VIX value indicates that investors expect significant market volatility, often associated with fear or uncertainty, and vice versa.
- Put/Call ratio: It is a ratio used to compare the market’s overall bullish vs. bearish sentiment, utilising the market data supplied by the relevant exchange, mostly the CBOE. A put option is a right to sell an asset at a predetermined price; a call option is a right to buy an asset at a predetermined price. Generally, if the ratio is greater than 0.7 or exceeds 1.0, it suggests a bearing sentiment as investors buy more puts; if it is below 0.7 and approaching 0.5, it is considered a bullish indicator as calls are relatively more than puts. One thing to note is that by default, there are more bearish traders in the market as bullish traders are more in a wait-and-see mode until an upcoming event occurs.
- High-Low Index: The index compares the stocks that are reaching their 52-week highs with stocks that are hitting their 52-week lows. It is a 10-day moving average of the record-high per cent indicator, which divides new heights by new highs plus new lows. A reading above 50 means more stocks are reaching 52-week highs; conversely, a reading below 50 shows that more stocks are making 52-week lows compared to stocks marking 52-week highs.
- Investor surveys/polls: Surveys from investment firms and financial institutions provide direct insights into investor sentiment. For instance, the American Association of Individual Investors (AAII) Sentiment Survey asks AAII members a simple question each week: ‘Do you feel the direction of the stock market over the next six months will be up (bullish), no change (neutral) or down (bearish)?’. The survey provides insights into retail investor sentiment, which can sometimes be a contrarian indicator.
- CNN Fear and Greed Index: This index gauges stock market movements and assesses whether stocks are reasonably priced. It compiles seven indicators: market momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe haven demand. The index ranges from 0 (extreme fear) to 100 (extreme greed).
Correlation between VIX and the S&P 500
Now, let’s focus on one of the most used market sentiment indicators, the VIX.
The relationship between the VIX and the S&P 500 is generally inverse, but this relationship is not always perfect. The chart below shows the study done by Macroption on the correlation between the S&P 500 (daily percentage changes) and the VIX (point changes) over a rolling window of 252 trading days, which is roughly one year.
We can see from the chart that the relationship appears weaker in the first half of the 1990s. However, its correlation improves over time, becoming relatively stable and oscillating around the -0.80 level. Additionally, another study conducted by Scott Bauer from CBOE reached a similar conclusion, indicating that the S&P 500 and VIX index have about an 80% correlation.
What are the limitations?
Although various studies have proven a relationship between the S&P 500 and VIX, we cannot rely on it entirely. Many sentiment indicators are lagging, reflecting past market conditions rather than predicting future movements, making it challenging to anticipate market reversals or capture significant turning points effectively. Additionally, indicators like surveys and polls can be influenced by biases, personal opinions, and limited sample sizes, potentially skewing results.
Sentiment indicators are best used in conjunction with other forms of analysis, such as technical and fundamental analysis, to confirm market turning points and provide a more comprehensive picture. For instance, acting solely on sentiment is less conclusive than acting on an extremely bullish sentiment reading combined with an extremely high P/E ratio, which could indicate an imminent downturn.
The fifth perspective
Market sentiment indicators are crucial in helping investors gauge the mood in the dynamic world of financial markets. By analyzing market sentiment, investors can gain valuable insights into potential market trends, reversals, and opportunities. While no single indicator can predict market movements with certainty, it is essential to use these indicators alongside other technical and fundamental analyses in your trading strategies to improve your chances of success in this ever-changing financial landscape.
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