Don’t Underestimate Market Sentiment

December 11, 2017

Don’t Underestimate Market Sentiment

  • Sentiment is perhaps the strongest market driver. We’ll discuss the current situation.
  • It certainly doesn’t pay to be a fundamental market arbitrageur.
  • Should you follow the trend or is there a way to be smart about it?


I’ve always preferred fundamental analysis, value investing, and looking for a margin of safety. That is still my main focus when analyzing and investing in a company, but I’ve learned that there is something no fundamental investor can disregard, market sentiment.

We can say without question that markets are irrational, but irrationality also means that it might take a long time for the market to understand its irrationality and correct itself. As Maynard Keynes would say:

“The market can remain irrational longer than you can remain solvent.”

Or though perhaps a much heavier statement but still excellent food for thought:

“There is nothing so disastrous as a rational investment policy in an irrational world.”

Let’s dig deeper into market sentiment and analyze the tools that can help us. These tools may not find us the best momentum trades, but they do offer something even more important, they prevent us from losing money which is the most important thing in investing.

Investing & Sentiment

The power of market sentiment was first analyzed by Delong, Shleifer, Summers, and Waldmann in their “Noise Trader Risk in Financial Markets” article published in 1990 in the Journal of Political Economy. They found that irrational noise traders with erroneous beliefs both impact prices and earn higher expected returns. The strength of the irrational traders deters arbitrageurs from aggressively betting against such sentiment. As a result, prices can significantly diverge from fundamental values for longer periods of time.

This is exactly what we have been witnessing lately. The S&P 500 is still in one of the longest bull runs in history and hedge funds, which are supposed to bet against the market, are increasingly leveraging themselves to buy equities.

Figure 1: Hedge funds are using more and more leverage to buy equities. Source: Goldman Sachs.

Similarly, short interest is low and it got even lower in 2017 clearly signaling that there is no point in fighting this bull market as the trend is extremely strong.

Figure 2: Short interest as a share of market cap. Source: Goldman Sachs.

However, an interesting sentiment indicator that takes into account the VIX index, fund flows, and other various sentiment indicators shows how when the market is positive, it’s best to sell, and vice versa.

Figure 3: Sentiment index by BNP Paribas. Source: Bloomberg.

When the sentiment index is positive, the usual consequence is a drop in stock prices. The same happened in 2007, and 2011, it didn’t happen in 2013, but did in late 2015. Given the hedge fund activity and fund flows discussed above, it isn’t strange that the current sentiment index is in positive territory which, if we take history into consideration, signals that we should limit our risks. However, as said above, the market can stay irrational for much longer.

Don’t Be The Arbitrageur

As the market can stay irrational for longer, it really doesn’t pay to be the one who sets the market straight. On top of it, a look at the 30-year S&P 500 chart shows how strong the trend is.

Figure 4: S&P 500 30-year chart – the trends are extremely strong. Source: Macro Trends.

In the past 30 years, stocks have been going either up for long periods of time, or have been falling in panic sales. As much as market timing might be attractive, a fundamental investor would have sold his holdings somewhere in the beginning of the 1990s when the CAPE ratio (cyclically adjusted price to earnings ratio) crossed 20, and perhaps bought back in somewhere in 2009 only to sell everything again in 2010 when the CAPE again crossed above 20. Thus, looking at fundamentals to time the market is definitely the wrong way to go.

Figure 5: The S&P 500 CAPE ratio has been above 20 most of the time in the past 30 years. Source: Multpl.

Arbitraging is even worse.

If you had shorted the S&_ 500 whenever it looked overvalued in the last 30 years, you would have been right twice, from 200 to 2002, and from 2007 to 2009. That’s 5 years out of the last 30, which means you would have been wrong 25 of the last 30 years, something no hedging strategy could sustain.

Nevertheless, the strength of market sentiment and extreme swings of the S&P 500 make many worry about the next crash. If stocks are driven up by positive sentiment, we all know that when the sentiment turns, all hell can break loose when those who were exuberant panic, not to mention all the margin calls on the excessively bullish leveraged hedge funds.

What Should You Do?

Many are now, after an 8-year bull market, sitting on lots of money in stocks, bonds, and real estate. However, those who were there in 2009, 2002, and some perhaps in 1990 and 1987, know that a crash is always around the corner.

Given that interest rates are extremely low, there is a big possibility that the next crash dwarfs all the above mentioned crashes, both in size and duration. I‘ve already discussed 7 hedging strategies one can apply to a portfolio, but given the current market situation, I’ll be digging deeper. So keep reading Investiv Daily for more independent insight on the markets and the economy.

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