"Negative sentiment is sweeping through the bourses" is a very common line that you hear in television channels. If anyone were to ask what does it exactly mean? The reply, most likely, would construe lines like, "Since the world markets are doing badly, India has to follow."
Reading the signs
Buoyant markets, whether primary or secondary, are often attributed to good market sentiment. Conversely, whenever the market pours ice-cold water on the hopes of many a day-trader and futures and option speculator, it is attributed to poor market sentiment.
In fact most market experts clearly say that markets are driven by both fundamentals and sentiment. And the latter is as important as the former.
So, given that the usual suspect in any short-term movement is ascribed to the "sentiment", it might be worth spending some time on the meaning of this word, and more importantly, what are the elements that make up this word in the stock market context.
Investopedia.com defines it as "The feeling or tone of a market (that is, crowd psychology). It is shown by the activity and price movement of securities".
As is apparent from this definition, there is an element of intuition or psychology involved. This can be summarised in just two words: greed and fear.
This aspect is completely neglected by the 'Efficient Market' theorists who propound that all market participants are rational human beings. Behavioural Finance practitioners, however, accord a lot of importance to such psychology.
Though 'sentiment' can be written-off as being largely short-lived, there have been attempts to quantify and pictorially depict these periodic emotional outpourings, through the medium of 'Sentiment Indicators'.
Such indicators attempt to gauge the composite market mood. However, unlike certain trend-following indicators (such as moving averages or trend-line breakouts), sentiment indicators generally are used to signal trend reversals.
Generally speaking, it means that when a sentiment indicator shows an abundance of optimism, investors would be wiser if they approach the market with a higher degree of caution.
The reasoning behind this is rather simple. If the vast majority of investors are very optimistic, then it follows that this positive outlook is getting translated into direct investment by them.
That implies that it would become more difficult progressively to find newer investors that provide an exit route to the existing investors. Therefore, sentiment indicators can point to major turning points in the market.
Here are some assorted examples of sentiment indicators:
Put/call ratio - A put option gives the purchaser the right, but not the obligation, to sell a security for a certain price by a specific time. Conversely, a call option gives the buyer the right, but not the obligation, to buy a security for a certain price by a specific time.
An extremely high put/call ratio indicates fear in the market, since more investors are betting on a downturn rather than an upturn.
On the other hand, an extremely low put/call ratio indicates an abundance of optimism, as investors are aggressively betting on future stock market gains.
Fund manager surveys - Many print and electronic media organisations conduct such surveys during the beginning of every calendar year. Usually, it is observed that, in case a vast majority of the responses are on any particular side (either bullish or bearish), it is very likely that exactly the opposite will happen during the course of the next year.
In fact investment professionals (as a group, rather than as individuals) often eclipse the weather department in terms of inaccurate predictions. In the US, the Yale School of Management Stock Market Confidence Index is based on investor surveys.
Volatility index - A high VIX reading indicates high volatility and tends to occur when fear is prevalent in the market. A low VIX reading indicates complacency, which is typically associated with stock market tops.
Though this VIX is associated with the Chicago Board of Options Exchange, the Securities Exchange Board of India has indicated that such a VIX for the Indian stock market should be launched soon.
Mutual fund data - There are other indicators as well, like mutual fund data that can be used to evaluate sentiment and gauge the excesses. When mutual funds are holding lower than average cash balances, there is usually less liquidity available for investing in stocks and is negative for the stock market outlook.
This often coincides with an extremely positive economic environment, which in turn, makes a stock market correction look extremely improbable.
The drawback involved in blindly following such sentiment indicators is that they are often too early in predicting trend reversals. Hence, even if a trend looks overextended, there are no set rules as to when it will end.
As the famous saying by John Maynard Keynes goes, "Markets may remain irrational for far more time than you can remain solvent". Hence, remember that while such indicators give you a clue, do not over react to them.
The writer is a certified financial planner