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Cory Mitchell, CMT is the founder of TradeThatSwing.com. He has been a professional day and swing trader since 2005. Cory is an expert on stock, forex and futures price action trading strategies.
Updated August 16, 2024 Reviewed by Reviewed by JeFreda R. BrownDr. JeFreda R. Brown is a financial consultant, Certified Financial Education Instructor, and researcher who has assisted thousands of clients over a more than two-decade career. She is the CEO of Xaris Financial Enterprises and a course facilitator for Cornell University.
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A sentiment indicator is designed to represent how a group feels about the market or economy. These market psychology-based indicators attempt to quantify sentiment in the form of figures or graphically to predict how current beliefs and positions may affect future market behavior.
Sentiment indicators look at how bullish or bearish market actors are and what they are thinking and feeling, which may help forecast investors' future behavior. When sentiment readings are unusually high or low, they may begin acting in a contrarian way. For example, when investors are extremely bearish, that is often a contrary signal to sentiment indicator traders that market prices could start heading higher soon.
Sentiment indicators can be used by investors to see how optimistic or pessimistic people are about the current market or economic conditions. For example, a consumer sentiment indicator, such as the Michigan Consumer Sentiment report, shows pessimism may make companies less likely to stock up on inventory, because they may fear that consumers will not spend.
The data is subject to interpretation. A high reading shows consumers are upbeat. Yet from a high reading, some feel it will likely head lower over time. A low reading shows consumers are downtrodden, but from there, things are likely to improve.
Sentiment indicators are just one piece of data and are not meant to be a timing signal for taking action. For example, if a sentiment indicator, such as the put/call ratio, has a very high reading (relative to historical values) that indicates investors are expecting stock market prices to decline. The contrary aspect indicates that prices will likely rise because there are few people left to keep pushing prices lower. What the indicator doesn't tell us is when that will happen. Instead, traders use the data to watch for turning points in prices when sentiment levels hit extremes.
When sentiment indicators aren't near extremes, they can help confirm the current trend. For example, a rising put/call ratio signals investors are pessimistic, which would help confirm a downtrend in price. Similarly, a falling put/call ratio would help confirm a rising price.
Policymakers may also use sentiment indicators with other economic data to help determine the future direction of interest rates, for example.
Investor biases and emotions play a significant role in shaping investment decisions. As you read through this article, think through how emotions and bias may lead to suboptimal outcomes and financial losses.
One cognitive bias is overconfidence, where investors tend to overestimate their ability to predict market movements and make successful investment decisions. People may feel overconfident in their position, leading to excessive trading, increased risk-taking, and a failure to adequately diversify their portfolio. Overconfident investors may neglect thorough research and due diligence, relying on their intuition to guide decisions that may not be backed by technical or data-driven support.
Another common emotional factor impacting investment decisions is fear. Investors often react strongly to market downturns or negative news, leading to panic selling and hasty decision-making. Again, this behavior driven by emotional responses rather than rational analysis can exacerbate market volatility and contribute to self-fulfilling prophecies of downturns simply because others around you are panicking.
Last, the herd mentality where investors follow the crowd without conducting independent analysis can lead to groupthink and market bubbles. The fear of missing out (FOMO) on a profitable trend or the desire to conform to market consensus can result in irrational decision-making; when this sentiment shifts, it can result in massive sell-offs. Therefore, approach the indicators below with caution and understand the risk of relying on how other people are doing.
Contrarian investors intentionally do opposite of what market sentiment indicators show, deciding to swim upstream from the popular investment choice.
Investors can use sentiment indicators to gain insight into the stock market’s mood. Extreme readings given by these indicators can indicate impending reversals. Here is a small sample of the sentiment indicators that traders and analysts might use:
Investors often view this indicator as the "fear index" because it spikes when investors purchase a significant amount of put options to protect their portfolios. Investors who buy put options believe the price of the underlying stock will fall. If the VIX spikes, it indicates fear within the market.
Investors can keep track of this indicator to compare stocks making new 52-week highs relative to stocks making new 52-week lows. Spikes in either direction often show extreme bullish or bearish sentiment. Contrarian investors might use this sentiment indicator to buy quality stocks during periods of severe pessimism.
This indicator shows how many stocks are trading above their long-term moving average and is expressed as a percentage. For example, if the indicator is rising and shows that over 60% of stocks are trading above their 200-day moving averages, it indicates a broad bullish sentiment. A reading over 80% suggests stocks may be overbought.
This indicator measures the number of shares being bought and sold in odd lots, which is less than 100 shares for most stocks. The theory behind this sentiment indicator is that retail investors, who typically have the least amount of money are likely to buy and sell odd lots, buy when bullish sentiment has peaked, and sell when bearish sentiment reaches a climax. Therefore, when odd-lot trading increases during market extremes, savvy investors may take a position in the opposite direction.
This weekly report shows the aggregate positioning of different groups of traders in the futures markets. A rising speculative position indicates a rise in that asset's price. When speculative interest hits an extreme, though, it indicates prices could head the other way.
Note that future put/call information can be used to predict future sentiment. For example, higher future puts may indicate less excitement about markets in the future.
While some sentiment indicators will also fall under the heading of a technical indicator, or vice versa, sentiment indicators are meant to show how consumers or investors have positioned themselves—or what their current beliefs are about the economy or market.
A technical indicator is a broad term used to describe formulas that manipulate the price or volume data (and sometimes other types of data) of an asset to provide a different perspective on what is happening on a price/volume chart.
Sentiment indicators are not timing signals. An extreme reading on the Commitment of Traders report doesn't mean the price of the asset will immediately reverse. Extreme reading can remain in place for a long time, or the price may stay where it is while traders unwind their positions and the extreme reading disappears without a significant price reversal.
Sentiment indicators are best used in conjunction with other forms of technical and fundamental analysis to help confirm market or economic turning points. For example, an extremely bullish sentiment reading, coupled with an extremely high price/earnings ratio (or deteriorating fundamentals), as well as a breakdown in price, provides more conclusive evidence of an impending downtrend than acting on sentiment alone.
This section may not directly relate to indicators; however, it highlights how market sentiment can drive markets and investor decisions.
The late 1990s and early 2000s witnessed the dot-com bubble's unprecedented rise and subsequent collapse. During this period, there was exuberant enthusiasm for internet-related stocks and technology companies. During the late 1990s, select companies outperformed their peers by 63% by changing the company's name to include technology terms such as ".com", ".net", or "Internet".
One key aspect of the dot-com bubble was the overvaluation of technology stocks, many of which had little or no earnings but were trading at astronomical price-to-earnings ratios. Historical notes show that Linux experienced a first-day return of almost 700%.
The bursting of the dot-com bubble in the early 2000s marked a sobering reality check for investors. Many technology stocks, which had experienced astronomical gains, saw their values plummet as the lack of underlying fundamentals became apparent.
The crash saw the Nasdaq, which rose five-fold between 1995 and 2000, tumble from a peak of 5,048.62 on March 10, 2000, to 1,139.90 on Oct. 4, 2002 (down 76.81%). Some may project that part of these losses were driven by investor panic, though that is speculation that can be difficult to substantiate numerically.
Unlike technical indicators that analyze price and volume data, sentiment indicators focus on gauging the emotions and attitudes of market participants. While technical indicators provide insights into market dynamics, sentiment indicators offer an additional layer of information by assessing the psychological factors influencing trading decisions.
Sentiment indicators play a crucial role in shaping trading strategies by helping traders identify potential trend reversals, confirm existing trends, or highlight periods of extreme optimism or pessimism. Traders often leverage sentiment data for risk management, and contrarian traders use it to identify opportunities that go against prevailing sentiment.
Sentiment indicators can be relevant for both short-term and long-term trading. Short-term traders may use them for intraday decisions, while long-term investors can incorporate sentiment analysis for portfolio management and identifying entry points over extended periods.
While sentiment indicators may signal heightened risk or extreme market conditions, predicting specific events like market crashes is challenging. They can provide early warnings and indicate when markets are reaching unsustainable levels, prompting traders to exercise caution. Be mindful that timing the market or attempting to predict when a market crash may happen is extremely challenging, if not impossible.
Market sentiment indicators are tools that assess the prevailing emotional tone of investors and traders, offering insights into whether the market is predominantly optimistic, pessimistic, or neutral. These indicators help anticipate potential shifts in market trends, providing valuable context for decision-making and risk management in financial markets.
