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Market Sentiment – the Basics

Market sentiment – the basics

You will learn about the following concepts

  • What is sentiment in trading?
  • In what way does it influence decisions?
  • Informed and uninformed market players

When we talk about market sentiment, we usually refer to the psychology or emotions of market players. Sometimes investors tend to make their decisions on feelings of fear and pessimism, while at other times their psychology is dominated by hope, overconfidence and even greed. As market participants react emotionally to the market, these emotions cause an impact upon market activity.

An example concerning the stock market

pencilThe stock market is an excellent example, which may explain what the term sentiment stands for. If we imagine a bullish market, where prices of stocks have been surging, investors, already taken a long position, will see the value of their portfolio expanding. People, who have not yet participated in the market, hear that their friends have made money trading these stocks, and as they are not willing to miss the opportunity of achieving such returns, they decide to enter the market. Every average investor usually expresses confidence that the tendency of climbing stock prices may continue. This confidence urges them to place more money in the market, thus stock prices will certainly advance. It is so, because as the number of investors entering trades grows, the demand for these particular stocks rises, which causes prices to soar. As optimism of market players dominates, this drives stock prices even higher. This optimism eventually turns into overconfidence and even greed, because investors see that their decision was correct. Being overconfident, players begin to buy stocks irrespective of value. Eventually optimism reaches a peak, while investors have already placed most of their disposable funds in the market. The amount of available money, which to support demand for stocks and respectively their upward price movement, is gradually waning. With this tendency deepening, there will eventually be no more funds to support rising prices, so the stock market registers a peak or a high.

The opposite scenario is also valid. As investors tend to be pessimistic and to fear for their investment, they begin to sell stocks. With pessimism taking hold of more and more investors, the number of participants selling the stock increases and this causes prices to decline. Witnessing the falling prices, more investors begin to fear and to sell their stocks as well. Eventually pessimism reaches a peak, while market players have withdrawn most of their funds from the market, thus a bottom or a low has been registered.

What does sentiment mean?

Optimists and Pessimists signpostSentiment stands for the net amount of any group of investors optimism or pessimism, which is reflected in any asset (tradable instrument) or market price at a specific time. If a stock or a commodity is being traded at a price, which considerably exceeds or is considerably below its intrinsic value (this appears to be unknown to a trader until some time in the future), the deviation from that value will usually be accounted for by sentiment. It represents the collective emotion and other intangible factors, which originate from the human interaction when deciding whether a price is over or below the supposed (intrinsic) value.

Technical analysts have long upheld the thesis that market prices are actually a combination of fact and emotion. If emotion appears to be excessive and prices deviate considerably from the norm (intrinsic value), a reversal in prices is probably about to occur. For a technical analyst is of utmost importance to be aware when prices reflect emotional extremes.

Investors and sentiment

In any market there are usually two types of participants – informed and uninformed. Prices in the market are usually determined by the interactions between these two groups.

uninformedThe uninformed players are those, who act irrationally, because often they are driven by their emotions and biases. They tend to be optimistic after a market has advanced and buy, which leads to market peaks, as we have seen in the above mentioned example. They also tend to be pessimistic during a bearish market and sell, which leads to market bottoms. Uninformed players are usually referred to as ”the public”, but however, even professionals can belong to that group. It is so, because what makes you an informed or an uninformed participant is the timing of your optimistic buying or pessimistic selling relative to market peaks or bottoms.

According to some researches, even professionals such as mutual fund managers or strategists at Wall Street often demonstrate the behavior of uninformed players.

We can conclude that the majority of market participants are uninformed participants.

informedThe other group of investors, the informed market players, are those, who act in a way that is contrary to the majority. They tend to sell at market peaks, when the majority demonstrates significant optimism and buy at market bottoms, when the majority is fearful and sells. Informed players are not necessarily professionals. They can be insiders from a particular company or simply day traders.

The uninformed participants have at their disposal a significantly larger amount of funds than the informed players. Every day the informed players stabilize global markets by taking actions when insignificant anomalies in prices occur, while the uninformed players tend to ”overwhelm the price action” with positive feedback. In many cases the informed players are forced to conform with emotion.

As maximum optimism and pessimism occur at price extremes and as the uninformed player makes decisions on emotion, if a trader relying on technical analysis is able to determine how each group of investors is acting, a certain knowledge of future price direction can be obtained. The informed professional may presumably act correctly, while the uninformed public may act incorrectly, especially when driven by extremes of emotion. If a technical analyst knows that the majority of market players are exceptionally optimistic about prices continuing to rise, he/she could be able to conclude that these participants are almost fully invested in the market and prices are probably nearing a peak.

A trader using technical analysis strives to make investment decisions, which are contrary to those made by the uninformed public, and to mimic decisions made by the informed participants.

price bubbleSometimes emotional excess can cause an extraordinary increase in prices (bubbles), or extraordinary decline in prices, also known as crashes or panics. During a bubble, stock market returns, for example, tend to be well above the average return. The occurrence of bubbles is evidence that prices are not always determined rationally. Emotion can dominate the market and send prices far beyond any reasonable value before a reversal manifests.

It can be frightful when most of the investors cannot perceive reality as it is, and their decision making becomes dominated by greed and other psychological biases.

Behavioral finance specialists attribute some of the biased behavior of market players to the so called crowd behavior, which we discuss in the next article.