What is sentiment?

Market sentiment is the overall attitude of investors towards a particular asset or market. It is the feeling or tone of the market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market. The market can partially be driven by emotion so market sentiment is not always synonymous with fundamental value.

Traditional financial valuation models are based on the concept of efficient capital markets in which investors make rational decisions taking into account all available information.  Prices reflect this information and investors allocate resources based on these efficient prices.

The drawback of these models and decisions made there upon is that investors are not always rational. Financial theory states that arbitrage should bring prices back in line whenever they diverge too far, however, research has shown there are limits to arbitrage.  In times of high speculation based on emotion, research has shown arbitragers pull out of markets leaving prices to stray far from their fundamental value.

Many studies have begun to document and analyse investors’ behavioural bias’s in finance.  They find, in particular, emotion, or sentiment, can affect an investor’s decision and drive prices away from their fundamental value.  Behavioural tendencies can lead to biased expectations of future prices causing bubbles and crashes.  This is a problem as financial models using quantitative data cannot account for the mood of investors in a market.  A solution to capturing the mood of a market can be found in the form of a sentiment index.

What is a sentiment index?

A sentiment index quantifies the sentiment of a market – whether investors are optimistic, pessimistic or neutral.  Qualitative data, in the form of questionnaires, is transformed into quantitative data.  An index can then be constructed which shows the trend of sentiment over time.

The interpretation of this index is simple, the market is either bullish (optimistic) or bearish (pessimistic) to varying degrees or neutral, a prime example being the VIX index as a measure of fear in the market.

A sentiment index is an extremely useful tool to aid market participants in their investment decisions.  It enables a view of market sentiment so changes in value perception are available sooner.  Additionally, the view of sentiment in a market may provide early signals of over-investment and signs of bubbles and imminent crashes.