Andrew Sheets: How Useful is Investor Sentiment?

While many investors may be curious to know what other investors are thinking about current and future market trends, there’s a lot more to the calculation of investor sentiment than one might think.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Thursday, June 9th, at 6 p.m. in London. 

I've found that investors are almost always interested in what other types of investors are doing. Some of this is curiosity, but a lot of it is interest in sentiment and a desire to try to quantify market emotion to give a better indicator of when to buy or sell. 

One can find a variety of metrics that portend to reflect this investor mood. Many of them move in nice, big, oscillating waves between fear and greed. But as anyone trying to use them as encountered, investing based on sentiment is harder in theory than practice. 

The first challenge, of course, is that there is little agreement in professional circles on exactly the best way to capture market emotion. Is it different responses to a regular investor survey? Is it the level of implied volatility in the market? Is it the flow of money in and out of different funds? The potential list goes on. 

Next, once you have an indicator, what's the right threshold to establish if it's telling you something is extreme? If you poll a thousand investors every week, maybe 70% of those investors being negative tells you the mood is sufficiently sour. But maybe the magic number is 80%, or maybe it's 60%. Defining positive or negative sentiment isn't always straightforward. 

Finally, there's the simple but important point that sometimes the crowd is right. Think of a long bull market like the 1990s. People were often optimistic about the stock market and correct to think so as prices kept rising. Meanwhile, people are often bearish in a bear market. We remember the dour mood that persisted throughout 2008. It certainly didn't stop stocks from going down. 

With all of this in mind, our research is focused on finding some ways to use sentiment measures more effectively. 

We think it makes sense to use a composite of different indicators, as true extremes are likely to show up across multiple approaches to measurement. Valuing both the level and direction of sentiment can be helpful. Rather than trying to catch an absolute extreme or market bottom, the best risk reward is often when sentiment is negative but improving. And sentiment is more useful to identify market lows than market peaks, as negativity and despair tend to be stronger, sharper emotions. Identifying peak optimism, at least in our work, is much harder. So don't beat yourself up if you can't find a signal that consistently flags market tops. 

Those ideas underlie the tools that we've built to try to turn market sentiment into signals as the age old debate around the true state of fear and greed continues throughout this year. 

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