Market sentiment refers to the overall attitude of investors toward a particular security or financial market. It is the feeling or tone of a market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market. In broad terms, rising prices indicate bullish market sentiment, while falling prices indicate bearish market sentiment.
Understanding Market Sentiment
Market sentiment, also called “investor sentiment,” is not always based on fundamentals. Day traders and technical analysts rely on market sentiment, as it influences the technical indicators they utilize to measure and profit from short-term price movements often caused by investor attitudes toward a security. Market sentiment is also important to contrarian investors who like to trade in the opposite direction of the prevailing consensus. For example, if everyone is buying, a contrarian would sell.
Investors typically describe market sentiment as bearish or bullish. When bears are in control, stock prices are going down. When bulls are in control, stock prices are going up. Emotion often drives the stock market, so market sentiment is not always synonymous with fundamental value. That is, market sentiment is about feelings and emotion, whereas fundamental value is about business performance.
Some investors profit by finding stocks that are overvalued or undervalued based on market sentiment. They use various indicators to measure market sentiment that help determine the best stocks to trade. Popular sentiment indicators include the CBOE Volatility Index (VIX), High-Low Index, Bullish Percent Index (BPI) and moving averages.
Indicators to Measure Market Sentiment
The VIX, also known as the fear index, is driven by option prices. A rising VIX means an increased need for insurance in the market. If traders feel the need to protect against risk, it’s a sign of increasing volatility. Traders add moving averages to the VIX that help determine if it’s relatively high or low.
The High-Low Index
The high-low index compares the number of stocks making 52-week highs to the number of stocks making 52-week lows. When the index is below 30, stock prices are trading near their lows, and investors have a bearish market sentiment. When the index is above 70, stock prices are trading toward their highs, and investors have a bullish market sentiment. Traders usually apply the indicator to a specific underlying index, such as the S&P 500, Nasdaq 100 or NYSE Composite.
Bullish Percent Index
The bullish percent index (BPI) measures the number of stocks with bullish patterns based on point and figure charts. Neutral markets have a bullish percentage around 50%. When the BPI gives a reading of 80% or higher, market sentiment is extremely optimistic, with stocks likely overbought. Likewise, when it measures 20% or below, market sentiment is negative and indicates an oversold market.
Investors typically use the 50-day simple moving average (SMA) and 200-day SMA when determining a market’s sentiment.
When the 50-day SMA crosses above the 200-day SMA – referred to as a “golden cross,” it indicates that momentum has shifted to the upside, creating bullish sentiment. Conversely, when the 50-day SMA crosses below the 200-day SMA – referred to as a “death cross,” it suggests lower prices, generating bearish sentiment.
Real World Example of Market Sentiment
Market sentiment turned bearish in December 2018 when several factors worked together to unnerve investors. Firstly, fears grew over slowing corporate earnings. After several years of double-digit earnings growth for many companies in the S&P 500, many analysts predicted that 2019 earnings would increase by just 3–4%.
Federal Reserve Chair Jerome Powell stoked those fears at his monthly press conference when he said the central bank’s balance sheet runoff was on autopilot. The market viewed his comments as “hawkish” and not accommodative for a slowing economy, which further dampened market sentiment.
Finally, unresolved trade tensions between the United States and China that saw tit-for-tat tariffs imposed by the world’s two largest economies throughout 2018, as well as a U.S. government shutdown, compounded with the issues above to severely damage market sentiment over the month.
Bearish sentiment damaged investor confidence that caused the stock market to have its worst December performance since 1931. The broad-based S&P 500 index fell 9.2% for the month, while the Dow Jones Industrial Index (DJIA), comprising of 30 industrial bellwether companies, shed 8.7% over the period.
The S&P 500 High-Low index fell below 30 in late December and remained near zero until mid-January, showing the extent of bearish sentiment gripping the market at that time.