Ideally, all prices of the stocks and funds you are tracking should always reflect fair value. This belief forms the foundation of the efficient market hypothesis. Under this theory, current market prices reflect all available information, news developments and variables concerning the markets and specific companies. As these factors are supposed to be priced into the asset and market prices you’re basing your investment decisions on, neither fundamental nor technical analysis should help investors gain an edge on securing excess profits. Therefore, alpha generation and gains should theoretically be impracticable.
However, this oft-criticized theory does not reflect reality. Instead, prices frequently adjust to news events, political and economic developments and other indicators. These movements often dictate whether retail investors ultimately assume risk and spend their hard-earned money on big purchases. The more confident individuals feel about the market, the more likely they will plan vacations, remodel their homes or purchase vacation properties. The more hesitant individuals are about the economy, the more thrifty they will be with their finances.
These short-term movements play into sentiment analysis, which offers a valuable perspective in investment decision-making. Sentiment analysis involves the study of particular feelings or attitudes of investors regarding the markets. Data from this analysis can provide insight into trends in the market that neither the efficient market hypothesis nor fundamental analysis can explain.
Sentiment analysis can be most effective as a contrarian indicator when price movements have become overly bullish or bearish. After all, retail traders tend to be reactive trend followers who base their buying and selling decisions on the market’s general direction or a particular company’s activities. Therefore, one could make successful sentiment-based trades by going against the grain of strong sentiment bias.
By following this strategy, investors can unearth attractive oversold positions. If investors’ sentiment toward the markets overall or individual stocks are pessimistic based on specific news developments, their uneven emotions can drive increased panic selling. As bearish sentiment strengthens, ensuing sell-offs can reveal buying opportunities since compounding selling would create inherent value.
Firms often track key sentiment indicators from various sources. Some of these are easy to identify or calculate. Others require more in-depth digging to unveil key sentiment signs. The benchmarks firms such as the JK Investment Group often use for measuring sentiment analysis include:
- The CBOE Put-Call Ratio, which measures the number of bearish to bullish stock market bets on options. The higher the ratio is, the more pessimistic investors feel about the markets.
- The CBOE Volatility Index (VIX), which measures near-term price fluctuations in the S&P 500. Because the index reflects S&P 500 index options’ pricing with near-term expirations, the VIX can project market volatility and consumer anxiety regarding the markets over the next 30 days.
- Breadth Ratios, which help forecast how bullish the market will be over the short-to-medium term. Firms calculate these ratios by dividing the volume of “up” stocks over “down” stocks daily, weekly or monthly. These ratios tend to signal a bullish market if the measured ratio of up stocks to down stocks is high and is consistently increasing over time.
- The High/Low Ratio Index, a 10-day moving average that confirms prevailing market trends of specific indexes, including the S&P 500. If the index is above 50, more stocks are reaching 52-week highs instead of 52-week lows. Such a finding would suggest positive market sentiment.
- Consumer and Investor Sentiment Surveys, which can forecast broad consumer and investing patterns that can foreshadow market performance issues. McKinsey, for example, regularly publishes survey-centered reports that combine consumers’ feedback with third-party data to predict future spending habits and other impactful developments.
- Social Media Sources, including Facebook walls, Twitter feeds, and Instagram feeds, can all provide helpful clues regarding consumer sentiment. A Netherlands study published by the European Central Bank found a strong correlation between Dutch consumer confidence and the sentiment displayed in public Facebook messages. This association was noted to be even more pronounced when the study’s authors factored in Twitter messages.
As 2022 progresses, sentiment analysis will play a key role in understanding how consumers and the markets respond to ever-changing developments. JK Investment Group will monitor these indicators and developments closely as we structure your portfolios for long-term success.
Securities offered through Regulus Financial Group, LLC. Member FINRA/SIPC. Investment advisory services offered through Regal Investment Advisors, LLC, an SEC Registered Investment Advisor. Registration with the SEC does not imply any level of skill or training. Regulus Financial Group, LLC and Regal Investment Advisors are affiliated entities. JK Investment Group is independent of Regulus Financial Group, LLC and Regal Investment Advisors.