What Is Market Sentiment and What Are Its Indicators?

Market sentiment indicators

Investors use several indicators to measure market sentiment. These help them determine the best stocks to trade.

• The Bullish Percentage Index (BPI) demonstrates how positive the market is. A high BPI (over 70%) shows bullish sentiment and may indicate that stocks are overvalued and the market is ready for a downturn. A low BPI (below 30%) suggests bearish sentiment, which means that the market is oversold and potentially ready to rise.

• The Market Volatility Index (VIX) is known as the index that reflects investor concern. The VIX measures the market’s expectations of future volatility, based on changes in option prices. Investors use the option price as a way to protect themselves from a potential price correction. A high VIX means investors in the market are concerned. A low VIX shows that market sentiment is stable and the current trend is likely to continue.

• The High-Low Index is a comparison of how many stocks have reached their maximum over the previous 52 weeks, versus the number of stocks that have reached their minimum over the same period. Below 30 indicates a bearish market. If the index is above 70, that reveals a bullish market.

• Moving Averages (MA) help identify when a market could be higher or lower. The percentage of stocks above or below key moving averages (e.g. the 50-, 100- and 200-day) signals whether the market is ready for growth or not. The 50-day MA and 200-day MA are usually used for determining market sentiment. When the 50-day MA crosses the 200-day MA from below, the market is considered bullish; if the 50-day MA crosses below the 200-day MA, the sentiment is bearish.

• Put/Call Ratio helps traders understand whether market sentiment is bullish or bearish. Put options give the investor the right to sell an asset at a specific price, while call options allow an asset to be bought at a specific price by a certain date. If more calls were bought, the ratio falls under 1, which means the market is bullish and investors expect prices to go up. On the other hand, if investors bought more puts, it means that the market is bearish.

• The Advance-Decline Line (ADL) is defined by the difference between advancing and declining stocks. You can see how many shares were bought and sold. With this indicator, you can understand whether market sentiment is pessimistic or optimistic.

• Trading Volume is one more indicator that you can use when planning your strategy. It demonstrates the total number of shares bought during a certain period. The higher trading volume is, the more interested in the market traders are.

• Commitment of Traders (COT) is a weekly report that demonstrates the aggregate holdings of different participants in the US futures market. This indicator provides a better picture of the dynamics of the market. The COT is published every Friday and shows the positions of the biggest investors — for example, corporations. According to Larry Williams, the creator of the COT index, if the COT index value is 75% or 25%, then this is a buy/sell signal depending on the market participants the index is being calculated for. Some other traders consider the critical values to be 10% and 90%. You can try to sell or buy shares around 20% and 80% and see which option is better.

Understanding Market Sentiment

The stock market is driven by the emotions of its participants, while fundamental value is about real business performance. Usually, market sentiment reflects the reaction of investors to different events, so this indicator may come out too late to be relevant, or may not demonstrate the real state of affairs. Always be careful with market sentiment indicators, because they can interfere with long-term investments.

Moreover, you should remember that the media can affect market sentiment significantly. Overly optimistic narratives can create bubbles, while negative news cycles may lead to panic selling. For instance, the media could increase the concern of investors during periods of economic uncertainty. Furthermore, there is a study that proves that sentiment in the media can identify early warning signs of an economic crisis.

You should not rely on market sentiment alone — there are other indicators for market analysis. For example, if the indicator shows bearish sentiment, and technical analysis demonstrates support for the business, then an investor may buy shares. Otherwise, a bullish sentiment combined with signs of overvaluation from fundamental analysis might require a more careful approach. 

Examples

Swings in the stock market between bullish and bearish sentiments are usually driven by uncertainty in economy and policy. For example, in the beginning of 2020 market sentiment was mostly bearish. Investors were expecting an economic crisis. Stocks were being sold massively, and prices were going down. Nevertheless, when governments took measures to stimulate the economy and scientists tested vaccines, investors became more positive, triggering a strong market recovery.

Sometimes social media can affect market sentiment. Just remember Tesla and its CEO Elon Musk. Tesla stocks fall and sentiment changes from optimistic to pessimistic on the back of his ambiguous social media publications, while the real state of affairs in the company is stable and there are no objective reasons for such a big fall.