When we talk about investment, we know that emotions play an important—and often detrimental—role. This time, we want to discuss market sentiment, which can be seen as a summary of investors’ emotions as a whole. As you will see, it has significant importance.
What is market sentiment?
Market sentiment is the general perception of investors regarding the economy or a specific market, which can be optimistic (bullish) or pessimistic (bearish). In English, the terms “bullish” (optimistic) or “bearish” (pessimistic) are used to describe the overall mood of the market. Although it is not a tangible indicator like economic data or technical analysis, market sentiment can have a significant influence on the direction of financial asset prices.
Now, just because it’s not tangible doesn’t mean it can’t be measured. The best-known indicator of market sentiment is the VIX index, sometimes referred to as the “fear gauge.” Created by the Chicago Board Options Exchange—the largest options market in the U.S.—the VIX attempts to provide a consistent measure of 30-day volatility in the U.S. stock market. The VIX typically rises when stocks plummet and falls during rallies—general price increases.
Another example is the descriptive Fear & Greed Index, developed by CNN. This “Fear and Greed” index looks at market movements to determine whether stocks are priced realistically. The Fear & Greed Index is a distillation of seven indicators, including market volatility, demand for junk bonds, and price strength.
How does It affect investors?
Market sentiment doesn’t always reflect the underlying economic reality. In fact, markets can overreact both upwards and downwards due to the emotional nature of investors. This disconnect between sentiment and reality is what can create opportunities (or risks) for investors.
Herd mentality
When market sentiment is extreme, whether bullish or bearish, it can lead investors to behave similarly, in what is known as herd mentality. During periods of extreme optimism, investors tend to buy en masse, which can inflate asset prices. Conversely, during periods of extreme pessimism, investors may sell en masse, leading to rapid and deep price declines.
Financial journalist Jason Zweig humorously discusses bear and bull markets in his “Devil’s Financial Dictionary.” Zweig says that a bear market is often said to occur when a broad stock market index drops by at least 20 points. But generally, a bear market happens when you can’t stop thinking that you should have sold your investments, which Zweig interprets as a clear sign that you should actually buy more.
At the same time, a bull market, for Zweig, is a period when investors believe their IQ has grown as much as, or more than, the value of their investment portfolios: after the inevitable fall, investors will learn that both rises were temporary.
Disconnect with fundamentals
Market sentiment can lead to a disconnect between asset prices and their underlying fundamentals. For example, in a strong bull market, stock prices may rise to levels that are not justified by the companies’ actual earnings. This creates asset bubbles that could burst when sentiment changes.
Contrarian investing opportunities
Contrarian investors try to capitalize on extremes in market sentiment. When sentiment is very pessimistic, they may buy undervalued assets with the expectation that prices will recover. Similarly, when sentiment is extremely optimistic, they may sell or reduce their exposure, anticipating a correction.
How to use market sentiment
Trying to gauge market sentiment can be useful, but it has its limits. In addition to indices, economic data, or global trends, social media also influences market sentiment. It’s been shown that reactions to news on these platforms and the tone of conversations often tend to exaggerate the perception of events or even distort them.
Our advice is to focus on the long term. Consistency is the best ally for an investor, especially when we have a diversified and balanced portfolio.
