How it is used in analysis and types

What is a sentiment indicator?

A sentiment indicator is designed to represent how a group feels about the market or economy. These market psychology-based indicators attempt to quantify sentiment, in the form of numbers or graphs, to predict how current beliefs and positions may influence future market behavior

Sentiment indicators look at how bullish or bearish market actors are and what they are thinking and feeling, which can help predict investors’ future behavior. When sentiment readings are unusually high or low, they can begin to behave in a contrarian manner. For example, when investors are extremely bearish, this is often a contrarian signal to sentiment indicator traders that market prices may soon start moving higher.

What do sentiment indicators tell you?

Sentiment indicators can be used by investors to see how optimistic or pessimistic people are about current market or economic conditions. For example, a consumer sentiment indicator, such as the Michigan Consumer Sentiment report, shows that pessimism can make companies less likely to stockpile because they may fear that consumers will not spend.

The data is subject to interpretation. A high reading shows consumers are optimistic. But from a high reading, some feel it is likely to be lower over time. A low reading shows that consumers are depressed, but things are likely to improve from there.

Sentiment indicators are just one piece of data and are not intended to be a timing signal for taking action. For example, if a sentiment indicator, such as the put/call ratio, has a very high reading (relative to historical values) indicating that investors expect stock market prices to decline. The opposite aspect suggests that prices are likely to rise because there are few people left to keep pushing prices down. What the indicator doesn’t tell us is when this will happen. Instead, traders use the data to watch for turning points in prices when sentiment levels hit extremes.

When sentiment indicators are not near extremes, it can help confirm the current trend. For example, a rising put/call ratio indicates that investors are pessimistic, which will help confirm a downward trend in price. Likewise, a falling put/call ratio will help confirm a rising price.

Policymakers can also use sentiment indicators along with other economic data to help determine the future direction of interest rates, for example.

Market sentiment indicators and behavioral finance

Investor biases and emotions play a significant role in shaping investment decisions. As you read through this article, think through how emotions and bias can lead to suboptimal outcomes and financial losses.

One cognitive bias is overconfidence, where investors tend to overestimate their ability to predict market movements and make successful investment decisions. People can feel overconfident in their position, leading to excessive trading, increased risk-taking and a failure to adequately diversify their portfolio. Overconfident investors may neglect thorough research and due diligence and rely on their intuition to guide decisions that may not be backed up by technical or data-driven support.

Another common emotional factor influencing investment decisions is fear. Investors often react strongly to market downturns or negative news, leading to panic selling and hasty decision making. Again, this behavior driven by emotional reactions rather than rational analysis can exacerbate market volatility and contribute to self-fulfilling prophecies of downturns simply because others around you are panicking.

Finally, the herd mentality where investors follow the crowd without doing independent analysis can lead to groupthink and market bubbles. The fear of missing a profitable trend (FOMO) or the desire to conform to market consensus can lead to irrational decision making; when this sentiment shifts, it can result in massive selling. So approach the indicators below with caution and understand the risk of relying on how other people are doing.

Types of market sentiment indicators

Investors can use sentiment indicators to gain insight into the stock market’s mood. Extreme readings given by these indicators may indicate impending reversals. Here is a small sample of the sentiment indicators that traders and analysts can use:

CBOE Volatility Index (VIX)

Investors often refer to this indicator as the “fear index” because it rises when investors buy a significant amount of put options to protect their portfolios. Investors who buy put options believe the price of the underlying stock will fall. If the VIX rises, it indicates fear within the market.

New York Stock Exchange (NYSE) High / Low Indicator

Investors can track this indicator to compare stocks making new 52-week highs versus stocks making new 52-week lows. Spikes in either direction often indicate extremely bullish or bearish sentiment. Contrarian investors can use this sentiment indicator to buy quality stocks during periods of severe pessimism.

NYSE 200-day moving average

This indicator shows how much stocks are trading above their long-term moving average and is expressed as a percentage. For example, if the indicator is rising and shows more than 60% of stocks trading above their 200-day moving averages, this indicates broad bullish sentiment. A reading of more than 80% indicates that stocks may be overbought.

Odd-Lot Trading Statistics

This indicator measures the number of shares bought and sold in odd lots, which are less than 100 shares for most stocks. The theory behind this sentiment indicator is that retail investors, who typically have the least amount of money, are likely to buy and sell odd lots, buying when bullish sentiment has peaked and selling when bearish sentiment has peaked. Therefore, when odd-lot trading increases during market extremes, savvy investors may take a position in the opposite direction.

The Commitment of Traders Report

This weekly report shows the aggregate positioning of different groups of traders in the futures markets. A rising speculative position indicates an increase in that asset’s price. However, when speculative interest reaches an extreme, it indicates prices may go the other way.

Sentiment Indicators vs Technical Indicators

While some sentiment indicators would also fall under the heading of a technical indicator, or vice versa, sentiment indicators are intended to show how consumers or investors have positioned themselves – or what their current beliefs are about the economy or market.

A technical indicator is a broad term used to describe formulas that manipulate the price or volume data (and sometimes other types of data) of an asset to provide a different perspective on what is happening on a price/volume graph happens.

Limitations of using a sentiment indicator

Sentiment indicators are not timing signals. An extreme reading on the Commitment of Traders report does not mean that the price of the asset will reverse immediately. Extreme reading may remain in place for a long time, or the price may stay where it is while traders unwind their positions and the extreme reading disappears without a significant price reversal.

Sentiment indicators are best used in conjunction with other forms of technical and fundamental analysis to help confirm market or economic turning points. For example, an extremely bullish sentiment reading, coupled with an extremely high price/earnings ratio (or weakening fundamentals), as well as a breakdown in price, provides more conclusive evidence of an impending downtrend than relying on sentiment alone step.

Example of market sentiment and investment

This section may not relate directly to indicators; however, it highlights how market sentiment can drive markets and investor decisions.

The late 1990s and early 2000s witnessed the dot-com bubble’s unprecedented rise and subsequent collapse. During this period, there was exuberant enthusiasm for Internet-related stocks and technology companies. During the late 1990s, selected companies outperformed their peers by 63% by changing the company name to include technology terms such as “.com”, “.net” or “Internet”.

One key aspect of the dot-com bubble was the overvaluation of technology stocks, many of which had little or no earnings but traded at astronomical price-to-earnings ratios. Historical notes show that Linux experienced a first-day return of nearly 700%.

The bursting of the dot-com bubble in the early 2000s was a sobering reality check for investors. Many tech stocks, which had enjoyed astronomical gains, saw their values ​​plummet as the lack of underlying fundamentals became apparent.

The crash saw the Nasdaq, which had risen fivefold between 1995 and 2000, tumble from a high of 5,048.62 on March 10, 2000 to 1,139.90 on October 4, 2002 (down 76.81%). Some may project that some of these losses were driven by investor panic, although this is speculation that can be difficult to substantiate numerically.

The Bottom Line

Market sentiment indicators are tools that assess the prevailing emotional tone of investors and traders, and provide insights into whether the market is predominantly optimistic, pessimistic or neutral. These indicators help anticipate potential shifts in market trends, providing valuable context for decision-making and risk management in financial markets.