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 attempts to quantify sentiment, in the form of figures or graphically, to predict how current beliefs and positions may affect future market behavior
Sentiment indicators look at how bullish or bearish market actors and what they are thinking and feeling, which may help forecast investors' future behavior. When sentiment readings are unusually high or low, they may begin acting in a contrarian way. For example, when investors are extremely bearish, that is often a contrary signal to sentiment indicator traders that market prices could start heading higher soon.
- Sentiment indicators gauge market psychology in the form of investor or consumer behavior and beliefs that may influence the market.
- When a sentiment indicator is moving in the same direction as what it is analyzing, that typically helps confirm that trend.
- Extreme readings on a sentiment indicator may cause some traders to take a contrarian view. For instance, "buy when there is fear, sell when there is greed".
- Sentiment indicators are used to analyze trends, assets, and the economy from the perspective of the participants involved, instead of just looking at an asset or data point isolation.
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 pessimism may make companies less likely to stock up on inventory, because they may fear that consumers will not spend.
The data is subject to interpretation. A high reading shows consumers are upbeat. Yet from a high reading, some feel it will likely head lower over time. A low reading shows consumers are downtrodden, it from there things are likely to improve.
Sentiment indicators are just one piece of data and are not meant 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) that indicates investors are expecting stock market prices to decline. The contrary aspect indicates that prices will likely rise since there are few people left to keep pushing prices lower. What the indicator doesn't tell us is when that will happen. Instead, traders use the data to watch for turning points in price when sentiment levels hit extremes.
When sentiment indicators aren't near extremes, they can help confirm the current trend. For example, a rising put/call ratio signals investors are pessimistic, which would help confirm a downtrend in price. Similarly, a falling put/call ratio would help confirm a rising price.
Policy makers may also use sentiment indicators with other economic data to help determine the future direction of interest rates, for example. (For further reading, see: How to Read the Michigan Consumer Sentiment Index?).
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 can indicate impending reversals. Here is a small sample of the sentiment indicators that traders and analysts might use:
- CBOE Volatility Index (VIX): Investors often view this indicator as the "fear index" because it spikes when investors purchase 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 spikes, it indicates fear within the market.
- New York Stock Exchange (NYSE) High/Low Indicator: Investors can keep track of this indicator to compare stocks making new 52-week highs relative to stocks making new 52-week lows. Spikes in either direction often show extreme bullish or bearish sentiment. Contrarian investors might use this sentiment indicator to buy quality stocks during periods of severe pessimism.
- NYSE 200-day Moving Average: This indicator shows how many stocks are trading above their long-term moving average and is expressed as a percentage. For example, if the indicator is rising and shows that over 60% of stocks are trading above their 200-day moving averages, it indicates broad bullish sentiment. A reading over 80% suggests stocks may be overbought.
- Odd-Lot Trading Statistics: This indicator measures the number of shares being bought and sold in odd lots, which is 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, buy when bullish sentiment has peaked, and sell when bearish sentiment reaches a climax. 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 a rise in that asset's price. When speculative interest hits an extreme, though, it indicates prices could head the other way.
The Difference Between Sentiment Indicators and Technical Indicators
While some sentiment indicators will also fall under the heading of a technical indicator, or vice versa, sentiment indicators are meant 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 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 chart.
Limitations of Using a Sentiment Indicator
Sentiment indicators are not timing signals. An extreme reading on the Commitment of Traders report doesn't mean the price of the asset will immediately reverse. Extreme reading can 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 (and/or deteriorating fundamentals), as well as a breakdown in price provides more conclusive evidence of an impending downtrend than acting on sentiment alone.