For the last few decades, much has been debated regarding the importance of psychology in the equity markets, more precisely in the formation of prices. As I have claimed many times before, not even with a grain of salt can one accept the idea of investors being rational and markets efficient. Many academic studies show evidence in the opposite direction; many traders make a living using technical analysis based on information on past prices; and many investors do beat the market and earn alpha. If markets were efficient none of this would be possible in a consistent and systematic way.
One of the most important effects influencing the minds of investors, their trading behaviour and ultimately equity prices, is sentiment. We all know that in everyday life we usually complete our tasks much better when we are happy and when sentiment is high. By contrast, when that mood is low, nothing seems to go right. We’re not machines, we’re influenced by mood.
When we transpose sentiment to the stock market, the scenario doesn’t change much. When investor sentiment is high, equity prices tend to rise more than when sentiment is low. But, as sentiment is a cognitive departure from rationality, the higher prices that result from it may also represent a departure from intrinsic value. If sentiment is high for an extended period, then the likelihood of a price correction occurring increases. Most of the time it comes in the form of a sudden correction.
Academic studies on the topic have been abundant lately. Sentiment is at the centre of price volatility and many are those trying to measure it with precision and to understand how it is formed. Particularly interesting is a very recent piece of research for the UK market conducted by Hudson & Green (2015) and published in the recently created Journal of Behavioral and Experimental Finance. They claim that sentiment drives equity returns and, most strikingly, that UK sentiment is “born in the U.S.A”. What they mean is that sentiment in the US may drive returns in the UK through a contagion effect. At the same time they say that sentiment is more significant during the tranquil periods when the market is rising and less significant during the stress periods when the market is declining and returning to rationality. Sentiment is a reverting process: high sentiment is followed by low sentiment and thus generates volatility in the stock market.
How to Measure Sentiment
Investor sentiment has been documented to play an important role in equity prices, leading to deviations from fundamental value. Most of the time, when sentiment is high, contemporaneous equity prices rise above their intrinsic values; and when investor sentiment is low, a correction tends to occur, which is often sudden rather than gradual. Prolonged periods of high sentiment often culminate with a crash, of which the latest financial crisis is a good example.
But then a question arises: how can sentiment be measured? After all sentiment is not tangible. It is a mood. We cannot measure it as we measure assets and liabilities or prices. What we know is that when the mood is good, investors tend to bid the prices of assets higher than rationality would allow for. Sentiment is then an unjustified belief about the future cash flows or risks of an asset. An ultimate result is higher equity prices, but it is difficult to understand how far those prices may deviate from intrinsic values.
There are three ways of measuring investment sentiment. The direct way is based on sentiment surveys. These surveys ask investors about their thoughts and expectations. In the U.S. there is a weekly survey conducted by the American Association of Individual Investors that shows how investors are split between bullish, neutral and bearish sentiment moods. The EU also conducts a few surveys, including the Economic Sentiment Indicator, which may act as a good proxy for general sentiment in the market (also available for the UK). But surveys are expensive and not widely available for all time spans. There are then indirect ways of probing the market by using widely available indicators. Examples include the put-call options ratio, the VIX or other volatility index, the ratio of stock advances to declines, the number of IPOs, the closed-end fund discount, and a series of technical indicators including trading volume and the relative strength index. A third option is another indirect take at the problem and rather difficult to implement as it makes large use of statistical methods. The main idea is that each of the indicators I mentioned above captures part of the sentiment. By using them all, one can build a composite index that captures sentiment in a better way than with any of these isolated measures. As this third option requires more quantitative knowledge, an investor can always opt for collecting data using the first two options and have a good grasp on how the investor mood is evolving over time.
Understanding the Impact of Sentiment in the UK
The research conducted by Hudson & Green builds a sentiment index using eight different market variables for the UK market and uses survey measures for US sentiment. What is really interesting is the fact that the UK measures only explain equity returns when the US sentiment is not included as an explaining variable. It seems that the main reason why sentiment varies in the UK is because it varies in the US. The reciprocal relationship doesn’t apply, which led them to say that sentiment in the UK is US-born.
In a globalised world there is no doubt that financial markets are highly correlated. With the US market being the largest by capitalisation, its influence is material in every other market. In the case of the UK, the tie between the countries is old, which helps us to understand why both markets may be more correlated than the US is with the Eurozone, for example. Another point to highlight is that according to data from 2012, foreign investors own 53.2% of the value of the UK stock market and 48.3% of these are US investors. So one quarter of the UK market is owned by US investors. It then makes sense that when sentiment rises in the US, these investors bid up not only the prices of US stocks but also of international stocks, an asset class where UK stocks assume a relevant role for them. The increase in sentiment in the US leads to an increase in sentiment in the UK.
Another important conclusion, which has been shared many times before, is that sentiment is a mean-reverting process that leads to price volatility. If sentiment did not exist in the first place, share prices would be much less volatile and not exposed to the crashes we observe from time to time. Fundamental value does change but not suddenly and in such large magnitudes. Sentiment is what drives the daily volatility we observe, as it is loaded with over- and under-reaction to news. Provided that sentiment is a mean-reverting process that often ends with a crash after prolonged periods of irrationality, we could see a crash as a necessary adjustment rather than a problem. One question that comes to mind: In preventing equity prices from declining, isn’t the central bank contributing to the next crash and to this whole sentiment process? That’s something to think about.