Sentiment Analysis – What is market sentiment and how does it affect the stock market?

November 04, 2020

In the long run, valuations may drive stock prices, but in the short term it is market sentiment that moves prices. This can create investment opportunities for long term investors to find attractive entry points, and for active traders to both enter and exit positions.

Market sentiment analysis is an evolving technique which can be effectively used to compliment fundamental, quantitative and technical analysis. Sentiment analysis is also one of the more successful methods of including the effects of market psychology in a trading strategy. Empirical evidence suggests that investor sentiment is one of the most reliable indicators of future price movements.
What is market sentiment?

Market sentiment is a qualitative measure of the attitude and mood of investors to financial markets in general, and specific sectors or assets in particular. Positive and negative sentiment drive price action, and also create trading and investment opportunities for active traders and long-term investors.
It could be described as the aggregated public opinions, views, feelings, mood, or outlook that make up the market psychology at any point in time. Because market sentiment cannot be exactly defined or measured, there is no specific correct or incorrect way to conduct sentiment analysis. Nevertheless, there are ways to use and combine other indicators that reflect market sentiment.
How emotions affect the stock market

In the short-term markets are driven by emotion – fear and greed in particular. Traders and investors are often driven by one form of psychological need or another. The fear of missing out, FOMO, can cause investors to pay prices for an asset that have no basis in reality. In that case they are not buying because the asset is a good investment, but because they need to do something to avoid the feeling of missing out. During bear markets, investors will often sell stocks at prices well below their value because they need to stop feeling the pain of losing money.
These are both examples of how emotions can force investors to make decisions that aren’t rational. It also shows why major market highs and lows are usually accompanied by extreme levels of positivity and negativity. Sentiment is highest just before major market tops, and lowest just before major market bottoms. By using sentiment analysis, investors can attempt to determine when the market is being driven by emotion rather than by rational decision making. They can pick up changes in sentiment before there is any news to explain the behavior of stock prices.
How to utilize sentiment analysis for trading

For the most part, sentiment should be combined with other forms of analysis to be most useful. Often the best opportunities occur when sentiment and fundamentals do not agree. Empirical evidence also shows that extreme sentiment readings very often occur at turning points. Ultimately what moves prices is what people in the market think, regardless of whether its rights agree with the fundamentals or not. Sentiment drives supply and demand, which in turn drives the price. It can also move the price in the same direction as the fundamentals, or in the opposite direction – and in the short term, sentiment often overrides fundamentals.
There are two opposing factors to consider when using sentiment to make trading decisions. Firstly, as long as sentiment continues to improve, prices will rise or stop falling. Likewise, deteriorating sentiment will cause prices to fall or stop rising. At the same time, rising sentiment can create overbought or bubble-like conditions, which will almost always result in a sharp reversal at some point. Negative sentiment can result in oversold conditions where stock prices become undervalued.
Using market sentiment to trade is therefore a case of being aware of how sentiment is changing, as well as the broader context, fundamentals and trends. As a trader you need to be aware of what might happen if sentiment begins to change in one way or another. The largest price moves happen when sentiment changes quickly, and when a large group of market participants switch from bullish to bearish or vice versa. The most profitable opportunities therefore exist when the conditions for rapidly changing sentiment are in place.                                                                                                             
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