Sentiments Used in Financial Markets - Essay Example

The market sentiment is the intuitive feeling of the investment community regarding the expected movement of the stock market. For example, if marketsentiment is bullish, then most investors expect an upward move in the stock market. Investor sentiment is simply the collective feelings, moods, beliefs and in some cases actions of a particular body of investors. Generally the most accurate sentiment indicators are those that reflect what they're doing as opposed to what they're feeling, although the latter are of some value as well. Sentiment is not an infallible indicator. There are no such things as infallible indicators. But if you have no feel for what the expectational environment is, you're kind of flying blind. You might have a good feel for the fundamentals and the technicals, but very often it's the expectational backdrop that makes the difference. For example, many investors are frustrated because they own a stock and the stock's earnings meet or perhaps even exceed expectations. And lo and behold, the stock goes down and people are at a loss to explain why. But for other stocks, the earnings come in and exceed expectations, and the stock skyrockets. Why the difference The reason is sentiment. Very often, the sentiment had been excessively bullish before the positive earnings report. In the days before the announcement, there may have been a heavy accumulation of call options. So there is a lot of anticipatory buying of the stock, which then pretty much has run its course when the earnings come out. A couple of organizations poll futures traders on their sentiment on the various futures markets. And the American Association of Individual Investors does weekly polls of its subscribers. But with these and other measures, you must wait until they get to some kind of extreme level before they carry contrary implications. For example, when everybody who could potentially be bullish is already bullish, then essentially most of the buying power in that particular market has been dissipated. At that point, the market becomes very vulnerable to selling because there isn't enough buying to offset the selling. Similarly, if only a very, very small percentage of market participants are bullish on a market, that essentially means that investors have taken their cash off the table. Perhaps they have even shorted the market. That means the market has become more primed to move upward because if buyers should come in they will not encounter much selling pressure because the selling has already occurred. So imagine a poll today that says 80 percent of futures traders are bullish. Remember that people, whether futures traders or individual investors or market-letter writers, tend to be trend followers. Their opinion tends to be a reflection of what's going on in the market. So if 80 percent are bullish that doesn't mean that the market is at its peak. No. 1, you would expect them to be bullish, and, No. 2, they can always get more bullish. I think this points out a trap that the bears have fallen into. They've noticed signs of bullishness, namely the amount of money that's flowing into mutual funds, the investment clubs, the Beardstown Ladies' books and so on. You get into trouble when a market is in a powerful technical trend and you analyze it without reference to the fact that you expect people to be bullish in a bull market. When a stock rises on positive earnings, which also occurs often, there may have been a lot of concern about the earnings report and investors may have bought a lot of put options, or shorted the stock. Without a measure of sentiment that is accurate, you can go down all kinds of blind alleys. Some of those who have been bearish on the stock market will tell you that there are many more investment clubs than there were 15 years ago, or that mutual funds now outnumber the stocks on the Big Board. These are all good cocktail-party things to talk about, but they're not really measures of sentiment that have parameters associated with them. They're just anecdotal. Academic researchers are mainly interested in elucidating an atypical occurrence in financial market with investors' sentiment. De Long et al (1990) divided investors into two types: rational arbitrageurs and irrational traders who are subject to sentiment. According to their research, irrational traders affect market price much more than the arbitrageurs. This result forms a basic assumption in behavioral finance, which is named as limitation of arbitrage. The diverse information is used as a proxy of investors' sentiment. The inexperienced retail or individual investors are subject to sentiment. Kumar and Lee (2006) suggest a sentiment measure, which is based on the retail investors trading. Moreover, investigators exploit many quantities, such as mutual fund flows, closed-end fund discount (Neal and Wheatley, 1998), initial public offering volume and initial premium, and trading patterns of insider. Additionally, (Bandopadhyaya and Jones, 2005) suggest an equity market sentiment index, which is based on the rank of daily return and the historical volatility. Wang (2003) presented a sentiment index, which is based on current net positions and historical extreme values. The research of Malcolm Baker and Jeffery Wurgler represent a frontier of this field. They showed that equity issues over total new issues, which are including equity and debt issues can be used to forecast market returns (Baker and Wurgler, 2000). Trading volume is closely related to the liquidity. From copious liquidity, investors feel stability in trading. It can positively affect the price of risky asset (Baker and Wurgler, 2004). To aggregate these measures, they suggest an investor's sentiment index. With this index, they inspected agreeable hypotheses. As results, they showed that investor sentiment may have significant effects on the cross-section of stock prices, and it is inclined to be affected by sentiment that stocks that have certain characteristics such as low capitalization, short history, unprofitability, high volatility, non-dividend paying and financial distress (Baker and Wurgler, 2006). Investor Optimism and Market Peaks: The evidence on median premia suggests very large premia in the third quarter of 1929, indicating excessive investor optimism. There may be several problems with these data. First, seasoned funds might be entering our sample because their premia are unusually large, and for this reason is reported in the sources we use. Second, a similar pattern to our findings could be accounted for by sluggish adjustment of reported net asset values. During a sharp market rise the measured premium will rise if the reported net asset value does not increase while the price does. Some additional evidence can be brought to bear on these objections. American European Securities is a fund that is likely to have smaller premia than the median, because it published its portfolio in 1928 and1929 at least in part to call attention to its management's view that it was undervalued in the market. Figure 3b presents the premia on this fund. At the beginning of 1929, the American European Securities Fund sells at a discount of more than 20 percent, even when there is no evidence that other funds sell at discounts. By the third quarter of 1929, American European Securities sells at a premium of 20 percent; while this is not as high as the median premium, it is large both by the standards of American European Securities' previous price relative to net asset value and by the standard of post-WWII experience. This premium has turned back into a discount by the end of 1929. The fact that a fund with premia small relative to those of other funds nevertheless sells at a premium of 20 percent in the third quarter of 1929 is strong evidence that large premia were the rule, not the exception. Our interpretation of procyclical closed-end fund premia is that investors overreact to good news, and therefore periods of high fundamentals are also periods of excessive optimism. This optimism is reflected, in particular, in high premia on closed-end funds. In principle, our empirical finding could also result from sluggish adjustment of printed net asset values to the true current market prices. Contrarian Investing: Contrarian investing is an investment strategy that seeks out securities, companies, or industries that are currently out of favor with the investing community. Contrarian investors may search out undervalued stocks, turnaround candidates, or cyclical companies nearing the bottom of a trough. Contrarian investors tend to do the opposite of what the majority of investors are doing. Contrarian investors examine various indicators, including odd lot trading, the index of bearish sentiment, and mutual fund cash positions. Contrarians are attempting to exploit some of the principles of behavioral finance, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors regarding the long-term prospects for the company. Odd-Lot Trading An odd-lot trade is a trade of less than 100 shares (called a round lot). Odd-lot trades are typically executed by individual investors. On the theory that individual investors are generally uninformed and incorrect, a contrarian investor would tend to buy when small investors are selling and sell when they are buying. By examining the ratio of odd-lot buying to odd-lot selling, contrarians can determine overall individual investor sentiment. Index of Bearish Sentiment The index of bearish sentiment attempts to measure the degree to which investment advisors are bearish. On the theory that the majority is usually wrong, a contrarian may interpret a rise in bearish sentiment as a buy signal. Mutual Fund Cash Positions Contrarians believe that the cash and cash equivalent position of mutual funds (excluding money market funds) can be an important indicator of market trends. As fund managers grow bearish, they tend to increase the cash position of their portfolios, and, as they grow bullish, the cash position tends to diminish. A contrarian would tend to interpret rising cash positions in mutual funds as a bullish signal. Dogs of the Dow: According to The Dogs of the Dow investment strategy popularized by Michael O'Higgins in 1991, an investor should annually select for investment the ten Dow Jones Industrial Average stocks whose dividend is the highest fraction of their price. Proponent of the Dogs of the Dow strategy argue that blue chip companies do not alter their dividend to reflect trading conditions and, therefore, the dividend is a measure of the average worth of the company; the stock price, in contrast, fluctuates through the business cycle. This should mean that companies with a high yield, with high dividend relative to price, are near the bottom of their business cycle and are likely to see their stock price increase faster than low yield companies. Under this model, an investor annually reinvesting in high-yield companies should out-perform the overall market. Of course, several assumptions are made in this argument, first, that the dividend price reflects the company size rather than the company business model and second, that companies have a natural, repeating cycle in which good performances are predicted by bad ones. How To Measure Whether The Market Has Moved Too Far In One Direction Seasoned analysts have several ways of determining whether sentiment has carried the market too far in one direction. By too far I simply mean that a change of direction is likely. Basic signs of an overbought market are: The market is reaching new highs. The vast majority of investors are optimistic about the prospects of further rises. News that would normally cause the market to fall has no effect while good news causes further rises. Authors fall over one another to publish new books about stock investing. There is a rush of IPOs (Initial Public Offerings, i.e. companies listing on the stock market for the first time) as entrepreneurs rush to cash in on the public's appetite for stocks. Mutual funds will have less cash than usual because a higher proportion of their capital will be invested in the market than usual. Most people are fully invested in the market - there will be little extra money available to push the market to new heights. The average guy in the street wants to talk about the stock market more than football. People who have not bought stocks will be told that they are missing a fantastic opportunity. A few crusty fundamental analysts will have been grumbling for some time that stocks are historically overvalued, but little attention will be paid to their gloomy prognostications - they will probably be accused of crying wolf and possibly ridiculed. Newspaper commentators and market-newsletters will have reached unusually high levels of optimism. They will be almost unanimous in the opinion that you need to have your money in this market. In these circumstances history indicates that a large fall in prices is likely. List of References: - Baker M., and Jeffrey W., 2007, Investor Sentiment in the Stock Market. Journal of Economic Perspectives 21, 129-151 Bandopadhyaya A. and Jones A. L., 2005, Measuring Investor Sentiment in Equity Markets, Working Paper, University of Massachusetts Boston De Long, J. B., Shleifer, A., Summers, L. H. and Waldmann, R. J., 1990, Noise trader risk in financial markets, Journal of Political Economy 98, 703-738 Dreman D., Contrarian Investment Strategies In The Next Generation, Simon & Schuster May 18, 1998 Kumar, M. S. and Persaud, A., 2001, Pure Contagion and Investors' Shifting Risk Appetite: Analytical Issues and Empirical Evidence, IMF Working Paper Wang, C., 2003, Investor sentiment, market timing, and futures returns, Applied Financial Economics 13, 891-898 Read More