Market sentiment can be integral in determining how stock prices move at any given time. Being able to gauge the mood of the market is a valuable skill, as it can allow you to make the most informed decisions possible when guiding client portfolios. A market sentiment indicator can help you conduct your analysis.
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What Is a Market Sentiment Indicator?
A market sentiment indicator is a tool that measures how participants in the market perceive it. Market sentiment indicators provide a framework for understanding psychological and emotional biases that may influence investor decision-making.
When market sentiment turns negative or investors feel anxious/afraid about what’s happening with the economy, that can prompt them to sell off assets. On the other hand, when sentiment is largely positive and investors feel optimistic, that can spur an uptick in buying.
The former behavior pattern can lead to a decline in stock prices and potentially contribute to increased volatility in the market. The latter, meanwhile, can push stock prices higher. Market sentiment indicators attempt to measure the trends that may arise based on investor emotions.
Types of Market Sentiment Indicators
There are several indicators advisors can use to analyze market sentiment and each one serves a different purpose. Here are seven common types of market sentiment indicators that you might consult when managing client portfolios:
- VIX (CBOE Volatility Index). The VIX is a short-term indicator that measures volatility over the next 30-day period. Also referred to as the fear index, the VIX is designed to track the movements of the S&P 500. A high VIX suggests increased uncertainty, while a low VIX indicates that investors feel largely positive about the market.
- Fear and Greed Index. The fear and greed index measures investor sentiment on a range from 0 to 100. A score of 0 indicates the mood is one of extreme fear while a score of 100 indicates a mood of extreme greed. The index is generally used to determine when the market may be over- or undervalued.
- High-Low Index. The high-low index looks at the number of stocks that have reached 52-week highs and compares them to the number of stocks that are sitting at 52-week lows. As to how that corresponds to market sentiment, an index under 30 hints at a bearish mood while an index above 70 suggests investors feel more bullish about stocks.
- Put Call Ratio. The put call ratio measures trading volumes of put options to call options. When more puts are being traded, that can indicate a bearish mood in the markets. If investors are trading more calls that suggests a bullish outlook.
- Moving Averages. A moving average represents the average price of a stock or a stock market index over a specific period. The most commonly used moving averages track stock prices over 50 and 200 days, respectively. How these moving averages intersect with one another can tell you whether investor sentiment is trending bullish or bearish.
- Bullish Percent Index. The bullish percent index measures the percentage of stocks within the index that are trending bullish vs. bearish. When the percentage of bullish-trending stocks is higher that indicates positive market sentiment. If the percentage is 50%, that suggests the market’s mood is neutral.
- Advance Decline Ratio. Advance decline ratio is a technical indicator that measures participation in the markets. It’s used to find the ratio of advancing issues to declining issues and can indicate when the market is oversold or overbought.
What Market Sentiment Indicators Can Tell Advisors
Market sentiment indicators are designed to offer insight into what’s driving investor behavior. Using sentiment as an analysis tool can help you to:
- Better understand the causes behind current trends and how long those trends are likely to last
- Assess the performance of different investments and identify potential opportunities to grow client portfolios
- Manage client risk exposure by identifying investments that have sparked a pessimistic mood among investors
Using market sentiment indicators can help you become more adaptable so that you can act quickly if necessary to counter rapid fluctuations in volatility. It’s important to keep in mind, however, that these indicators are not without certain limitations.
Sentiment indicators measure investor psychology, not the fundamentals of any specific stock or market sector. The way that investors feel about a particular investment or the economy may sometimes result in behaviors that don’t reflect the true nature of the market.
Investors’ perceptions of the market may be skewed by misleading news story headlines or clickbait posts on social media. As an advisor, you have to be able to filter out the noise to determine what’s happening in the markets and how it’s affecting investor sentiment.
How to Use Market Sentiment Indicators to Manage Client Portfolios
Market sentiment indicators are an often helpful—but imperfect—tool for analyzing the market. Here are some things to keep in mind when using sentiment indicators to direct your decision-making when advising clients.
- Sentiment may be rational or irrational. Market sentiment indicators tell you what investors are feeling about the market, not why they’re feeling that way. In addition to reading the room, so to speak, you must be able to discern whether the current sentiment has any rational basis.
- Market sentiment isn’t an exact predictor. Sentiment indicators often provide more insight into where the market has been rather than where it may be headed next. That means you can’t rely on them alone to guide investment decisions for your clients.
- Investor sentiment is often contrarian. A market sentiment indicator may be trending bullish or bearish, but historically, outcomes don’t always reflect what investors are feeling. Taking a contrarian view of sentiment can help you identify the market top and bottom, and where the opportunities may lie.
Lastly, remember that sentiment indicators aren’t the only analysis tool you have at your disposal. Analyzing market sentiment alongside economic indicators, historical data and real-time price information are all part of a comprehensive approach to portfolio management.
Frequently Asked Questions
What Is the Best Indicator of Market Sentiment?
One of the most frequently used indicators of market sentiment is the CBOE Volatility Index or VIX. The VIX is a forward-looking indicator that measures volatility in the for the next 30 days. Movements in the VIX often mirror movements in the market, as a higher index suggests increased volatility and a lower index hints at greater positive sentiment.
How Do You Identify Market Sentiment?
Market sentiment is largely identified through adjustments in stock prices. As sentiment trends more bullish, stock prices are often driven higher as a result of more investors buying into the market. When sentiment is bearish, stock prices may drop as investors pause buying activity or sell off some of their holdings.
Is Sentiment a Contrarian Indicator?
Market sentiment indicators are often viewed as being contrarian among financial advisors and investment experts. History suggests that when sentiment is moving one way, it often results in an opposite reaction. Taking a contrarian approach can allow advisors to spot openings to capitalize on those trends for the benefit of their clients.
Bottom Line
Knowing how to analyze market sentiment indicators can help you better serve your clients day to day and in the long term. Making informed decisions becomes easier when you understand the role that psychology plays in investor behavior.
Tips for Growing Your Advisory Business
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- Market sentiment focuses on technical analysis so it’s important to consider where fundamental analysis fits into how you manage client portfolios. Most financial planning software programs for advisors include fundamental analysis tools as well as visualizer tools that can be helpful in decision-making. If your current software lacks these options, it may be time to consider an upgrade.
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