What Is Market Sentiment?

How Market Sentiment Works

Market sentiment is more often supported by trendlines on pricing charts rather than fundamental facts about a security, asset, or market.

Many things can affect how people feel toward a market or security. Those things can be as minor as a rumor or trending news headline, or as major as an earnings release, economic update, or foreign relations with another country that affect people's attitudes toward a market.

Market sentiment becomes increasingly important to learn about with the rise of investing fueled by social media trends or meme stocks.

Let's consider the S&P 500 index, a common index used to measure the overall performance of the U.S. stock market. If everyone had a positive sentiment toward the U.S. stock market, the S&P 500 index would likely be trending in an upward direction. Conversely, if everyone had a negative sentiment toward the U.S. stock market, the S&P 500 index would likely be trending in a downward direction.

Example of Market Sentiment

For example, excitement about technology and innovation made investors bullish about technology stocks in the late 1990s. That fueled the growth of multiple technology start-ups, many of which had blockbuster IPOs and received exuberant valuations, popularly known as the “dotcom bubble.” But that bullish market sentiment was not necessarily supported by strength in the companies’ fundamentals, which eventually led to a market crash in 1999-2000.

Types of Market Sentiment

Investor sentiment can be classified as three categories depending on price expectations:

• Bullish: Investor sentiment is considered “bullish” or positive when investors are expecting the stock market or the price of security to rise.
• Bearish: Investor sentiment is considered “bearish” or negative when investors are expecting the stock market or the price of a security to fall.
• Neutral: Investor sentiment is neutral when investors expect the stock market or the price of a security to neither rise nor fall significantly.

Indicators of Market Sentiment

Market sentiment is often measured through technical indicators that serve as forecasters for the future movement of a security or market price. Some common technical indicators used to measure market sentiment include:

• VIX index: The Chicago Board Options Exchange Volatility Index, aka the VIX index, measures the expected volatility of the U.S. stock market by measuring the options prices of the S&P 500 index.
• Moving averages: A moving average is a series of means, or averages, plotted on a graph in comparison to a current security’s price. It’s “moving” because the average changes on a day-to-day basis as determined by the current securities price. So, for example, if an investor takes the 50-day moving average of a security, and the current price of that security is below the 50-day moving average, one can conclude that the current market sentiment is bearish.
• Volume: Volume is the number of shares traded on a particular security and can be a great indicator of how investors feel toward the underlying security. If there is a high volume of sell transactions, this may indicate a bearish sentiment. Conversely, if there is a high number of buy transactions, this may indicate a bullish sentiment.
• High-low index: This index measures the strength or weakness of a particular index by dividing the sum of new highs and dividing it by the sum of new highs and lows during a given time frame. Values above 70 may indicate a bullish trend, and values below 30 indicate a bearish trend.

Other ways of measuring market sentiment are via sentiment surveys such as the American Association of Individual Investors (AAII) investor sentiment survey. The AAII survey is sent out to individual investors, asking their thoughts on where they think the stock market will go in the next six months. This survey is sent out weekly and has been since 1987; it serves as a great indicator of the overall investors' attitude toward the stock market.

Market Sentiment vs. Fundamental Analysis

Market sentiment and fundamental analysis are both ways for investors to understand the pulse of the market better, but they are two very different approaches to learning about where the market is headed.

What It Means for Individual Investors

Market sentiment is a great way to give context to your investment research. Understanding the market sentiment can help investors make investment decisions that align with their objectives.

Further, market sentiment is not always based on fundamental facts of a market or company and does not always indicate the future movement of an investment or market price. For example, in April 2020, the market experienced significant losses, but investors' expectations did not fall accordingly. Despite losses, investors continued to invest in anticipation of a positive turn for the markets.So, market sentiment alone should not be used as the basis of an investment decision.

Frequently Asked Questions (FAQs)