Some Sentiments on Sentiments
January 24, 2008 by MTM
This market right now is moving on nothing more than emotions. Guess what? It almost always moves on emotions.
- David Bach
The term "investor sentiment" is widely used in financial press. If we zoom in on the word sentiment, the easiest defintion is:
"A thought, view, or attitude, especially one based mainly on emotion instead of reason."
By now, FMers are familiar with the chart showing the cycle of investor emotions. Here's a larger version from a related website (link below):
The words are very descriptive, and capture the general flavor of financial press and trader sentiments at certain times. However, markets are wilder and not as smooth as the graph suggests.
Our vivid chart above evidently does reflect sentiment–but it seems to lack something vital: it's very one-sided! Remember that a market transaction at its base has TWO participants: a buyer and a seller. It might be just as important to understand that at every point in time there are not just one, but at least TWO emotions at play.
This is relevant regardless of whether a market allows two way trading, i.e. long buying and short selling or just one way, long-only (like ours).
Sometime in last year, I half-seriously suggested on the forum that we come up with an automated counter to track the instances certain words and phrases pop up as an indicator of forum sentiment. Words with often colorful and imaginative indications like:
- bloodbath
- meltdown
- recession
- rate cut
- bounce
- dead cat bounce
- all time high
- new high
- growth
- get out
- buy/bought
- sell/sold
- blood on the streets
- hope
- good luck
- hold
- breakdown
- breakout
- support
- resistance
- foreign
Other approaches:
- Count the average number of words/characters in people's posts.
- A more controversial approach would be to count the number of posts coming from certain posters, you ever think that certain forumers appear prominently during certain times? Although this latter version will end up alienating the audience, especially the forumers concerned.
- Something just as controversial: track how many "alternicks" emerge (i.e. new posters appearing with similar/identical IPs as older posters who have suddenly stopped posting).
I can think of even simpler counters that might do the same:
- The number of certain kinds of emoticons that appear on posts over a given period.
- The average number of exclamation marks: "!" that appear over a given period.
Any of the above approaches are interesting and would help give us a flavor of investor sentiment, using the FM forum as a proxy. Meanwhile, to address our one-sided chart above, let's attempt a come-back. For more fun (and realism) let's try to view it with multiple personalities: both a buyer and a seller.
We can redraw our chart, using market points where emotions flare up and war with each other. It's not a smooth S-curve actually:
Take note: This is not a new form of technical analysis or Elliot Wave. This is just a sylized representation of where polarized opinions can emerge. I borrowed the terms from our original chart above and flipped them around so that at each point, the buyer and seller will have the exact polar opposite sentiment:
And now we can imagine a hypothetical conversation between a bull and bear during certain market points (note the similarities with some FM posts):
1. Market Rallies
Bull: Everything's fine!
Bear: How high can it go?
2. Uptrend Accelerates
Bull: What a Market!
Bear: Irrational! Things are so expensive!
3. Market High
Bull: I'm gonna be rich!
Bear: I gotta get out now!
4. Correction
Bull: We're now in a bull market.
Bear: How could I have been so wrong?!
5. New High/Test of High
Bull: This market's unstoppable.
Bear: Market? Feh!
6. Break
Bull: It will come back.
Bear: Thing's are just beginning.
7. Crash
Bull: How low can it go?
Bear: Everything's going to hell.
8. Downtrend accelerates
Bull: Irrational! Things are so cheap!
Bear: What a market!
9. Market Low
Bull: I gotta get out now!
Bear: I'm gonna be rich!
10. Bounce
Bull: How could I have been so wrong?!
Bear: We're now in a bear market!
11. New Low/Test of Low
Bull: There's no hope!
Bear: This market's unstoppable!
12. Breakout
Bull: A light at the end of the tunnel!
Bear: It will come back.
Bi-polar freaks we all are! But I'll leave the psychobabble to academics, who are exploring this phenomena in a relatively new economic field called Behavioural Finance (links below). Meanwhile, it's just fun to poke at our neurotic selves, especially in light of recent events.
Happy Trading folks!
~Mark T. Market
Related links and readings:
The cycle of investor emotions
http://qsuper.qld.gov.au/public/members/educational_tours/FYF/07w-Investoremotions.asp
Behavioural Economics and Behavioural Finance Resources:
http://www.behaviouralfinance.net/
http://en.wikipedia.org/wiki/Behavioral_finance
excellent article boss MTM!
Great educational and interesting read MTM. Nice follow up to the gold article. In my trading, I check on three factors, namely, Technicals, Fundams, and MARKET SENTIMENT. When all three line up together (not a frequent occurrence), the chance of success of the trade is very high. How do I determine short-term mkt sentiment? I base my rating on market reactions to breaking fundamental news. If bullish news comes out, the price action should be positive. If the market ignores bullish news, then short-term sentiment is negative. If the market explodes higher on a bit of supportive (mildly bullish) news, then short-term sentiment is positive.
Thanks bosses ericgo and choobeebo.
In the recent equity market panic, I had a conversation with a friend, who is an equity analyst, where we were asking: what’s being discounted with prices being beaten down so much, when the fundamentals have not changed much from two weeks ago. The likely arguments were to imagine that either a) fundamentals were being mispriced or b) there is a change being reflected in the price, but the exact reasons are not yet known.
The two ideas work well for most cases. However, it helps to have a 3rd option: that participants can get “carried away” with sentiment, which then moves prices at usually disproportionate odds with the underlying factors. So prices have a tendency to overshoot, both on the positive (creating bubbles) and the negative (creating crashes). Either way, it keeps a trader grounded in reality to know that such a process does happen in the market, and keeps us from getting carried away ourselves. Ultimately it can save us a lot of money by filtering out investments/trades where sentiment skews the risks. Also it can help us in trades when we know sentiment is working in our favor. Really good stuff!