Sentiment analysis is really the study of crowd behaviour, revealing expectations, forecasts and views of investors and players within the market. After all, the market is not composed of a single party but rather, an innumerable number of participants, which range from speculators to traders to long term investors. The investing style and mentality of market participants range the gamut. However, when the crowd agrees on something, market moves tend to reflect the fear or over optimism prevailing the market.
Some incidents may be illustrative of this crowd psychology. An apt example is that of the subprime crisis in 2008. When the markets in the US were undergoing one of the most severe financial shocks the world has ever seen, indexes such as the Hang Seng or Straits Times followed suit. Contagion seems to have a domino effect on other participants. In time, that panic spread globally and all major market indices were down.
Another apt example is that of the dot com craze which eventually resulted in a bubble. Analysts and experts were of the view then that technology stocks were a trend that would continue indefinitely. Human beings have this weird tendency to put an arrow at the end on a rope and extrapolate it as if the arrow was being shot upwards. So many turned out to be wrong. In fact, the facts were there for all to see. Technology stocks were trading at incredibly high multiples with little to no earnings. Eventually, the market tanked and all international indices followed suit.
While these are just 2 classic examples taken from the pages of history which are examples of over optimism and panic, history is replete with these events, occurring ever so often.
Depending on an investor’s style of investing, the investor may want to do some sentiment analysis. For example, traders may want to be trend following and may use sentiment analysis for their validation while long term investors may want to be contrarian and so, they use sentiment analysis for exactly that purpose.
In this article, we will discuss several indicators that may paint a picture of the sentiment in the market.
Put/call ratios are the number of puts divided by the number of calls traded on an exchange. Data regarding put/call ratios can be found on www.cboe.com. Since the numerator is representative of the number of puts, a higher ratio is a bearish signal. On the other hand, a lower ratio means more calls and hence may be a bullish signal.
Short Interest Ratio
The short interest ratio indicator is the ratio of short interest to average daily volume. A ratio of less than 1 is bearish. On the flipside, a ratio of more than 1.75 is bullish.
Market PE ratio
The market PE ratio is an indicator of market undervaluation or overvaluation. For example a market PE ratio of less than 8 could be a bullish sign for a contrarian while a market PE ratio of more than 20 could be a bearish sign for a contrarian.
A low yield is a sign of overvaluation of the DJIA while a high yield may be a sign of undervaluation for the DJIA. For example, if the DJIA yield is greater than 12%, it is a sign that the market as a whole is undervalued whereas a yield of 2% would be a sure sign of overvaluation.
Sentiment analysis should be used with fundamental analysis, technical analysis and economic analysis to get a good overview of the markets.