Understanding the stock market demands more than just mathematics. Wise investors also have to understand human behavior.
More specifically, it’s important to understand how market sentiment impacts the stock market. What does sentiment mean in stocks? What are some of the most common stock market sentiment indicators?
Read on, and we’ll help you understand more about this subject, and how it might impact your investment strategy.
What Does Sentiment Mean in Stocks?
What is market sentiment? At its simplest, market sentiment refers to the overall attitude that investors have. This sentiment can be directed at the market as a whole, or it can be directed toward a particular stock.
You may already have heard of “bullish” and “bearish” sentiment. A bullish sentiment is revealed in rising stock prices, while bearish sentiment is revealed in falling prices. Basically, it’s herd behavior, so it can reflect the overall confidence or fears of a group of investors.
What is Market Sentiment Caused By?
Understanding investor behavior is an exercise in psychology and human behavior. Two broad theories have been used to explain investor behavior.
The Behavioral Financial Theory argues that investor behavior is fundamentally irrational. This means that investors tend to shift their investments based on emotion or their “gut” more than a set of universal financial rules.
The Animal Spirit Theory offered by John Maynard Keynes has argued that individuals are dominated by their instinct, which usually means they’ll flock to successful stocks. But surprisingly, investors will cling to underperforming stocks to mitigate their losses.
What Is Sentiment in Stock Market Investing?
How might sentiment impact your investment strategy? Some investors can take advantage of market sentiment by buying and selling based on prevailing trends.
In other words, you might generate a profit by buying undervalued stocks or selling overvalued stocks based on the overall market sentiment.
Not all investors adopt this approach, however. Contrarians prefer to buy or sell in the opposite direction as anyone else. Why would they do this? Basically, contrarians argue that the crowd isn’t a reliable indicator of stock market success. Instead of following the crowd, they run in the opposite direction.
Which of these approaches is best? There’s a lot of debate about that subject, and it’s not always clear which approach is best. Human behavior is notoriously hard to predict, just as the market’s actual performance is equally challenging to forecast.
But according to the Hulbert Financial Digest, “Extreme bullishness that endures several months is a much more bearish sign than optimism that lasts just a week or two.”
In other words, sometimes, it’s important to map market trends over time rather than jumping to immediate conclusions based on recent performance.
What is Market Sentiment in 2021?
As you can imagine by now, market sentiment tends to be volatile. But some market analysts are seeing bullish sentiment reach “pre-pandemic levels,” according to Business Insider.
However, this could also indicate a market bubble, though this notion has been rejected by major firms including Goldman Sachs.
How investor behavior will impact the market as pandemic restrictions continue to lift is unclear, but this unusual time reveals just how dramatically the stock market can be influenced by investor confidence—or the lack thereof!
Understanding Stock Market Sentiment Indicators
There are four major stock market sentiment indicators, and it’s important to understand how each one works.
The VIX (or “Fear Index”)
The volatility index (VIX) was created by the Chicago Board Options Exchange (CBOE) to gauge the volatility of the market over a 30-day period.
Most notably, the VIX is based on future market performance, which is why it’s more commonly known as the “fear index.” A climbing reading on the VIX indicates increased risk associated with the market, since prices might change substantially in the future.
On the flip side, a low reading on the VIX indicates a much higher level of stability.
The High-Low Index
In the high-low index, the number of stocks making 52-week highs is compared to the number of stocks making 52-week lows. This provides a snapshot of the market’s performance over the last year.
Bullish market sentiment is found when the high-low index is above 70, while bearish market sentiment is reflected when the high-low index drops below 30.
Typically, traders will apply these indicators to a particular index, such as Nasdaq or the S&P 500.
Bullish Percent Index (BPI)
The bullish percent index (BPI) uses point and figure charts to determine the number of stocks with bullish patterns. A market with a bullish percentage around 50% is considered to be neutral. When the index is above this mark, it is considered bullish, and when it rises above 80%, the market is considered extremely optimistic, indicating that stocks have been overbought.
Conversely, when the BPI dips to 20% or lower, it indicates a great deal of market pessimism and an oversold market.
There are two types of moving averages that investors can use to determine market sentiment: the 50-day simple moving average (SMA) and the 200-day SMA.
As the name may imply, the simple moving average provides the overall movement of a stock index during the specified time frame. These can be some of the more common stock market sentiment indicators. They may be combined with other methods such as the VIX in establishing stock market sentiment.
There are two related terms to understand regarding moving averages. A “golden cross” occurs when the 50-day SMA crosses above the 200-day SMA. This results in a bullish sentiment.
When the 50-day SMA crosses below the 200-day SMA, it forms a “death cross,” indicated bearish market sentiment.
Don’t Let Fear Dictate Your Finances
Sometimes, keeping a level head and focusing on stock performance can help you to stay focused regardless of sentiment. At Gorilla Trades, we can provide you with the tools and resources you need to make the best decisions for your investments!
Sign up today to enjoy a free, 30-day trial of all our great resources, and see where your investments can take you.