Using Investor Sentiment to Map the Markets
A technique used by racing drivers can help you make better investment decisions.
Racing drivers are lucky. You see, the tracks that they race on don’t change very much from year to year. I haven’t driven at Lime Rock Park since 1999, but I’d find few surprises if I set out to lap it today. There’s new pavement, but I hear that there’s still a nasty bump right at the apex of that fast right hand downhill turn.
If I ever race again at Lime Rock, I’ll be able to prep for it, too. I’ll watch videos of other drivers’ hot laps. I’ll race it on a driving simulator in my basement. I’ll even run through old races in my mind, remembering the sounds and smells, and how I could feel the rear end of my car drifting as I sped through West Bend at over 70mph.
The most valuable thing I’ll do, however, is with pen and paper. I’ll use a map of Lime Rock to develop a strategy that includes notes on the proper racing line to maximize my speed and when to brake and how hard. I’ll even prioritize the corners. Some can be taken at top speed. Others might be throwaways, corners taken at lower speed in order to set up for a faster racing line in a more important corner. I’ll even consider alternative lines that I can use for passing my competitors.
Here’s my map of Lime Rock.
It’s a 1.5 mile track comprising seven turns, six of which are right handers. There’s an uphill turn and a downhill turn. Each is challenging. The track looks deceptively simple. It’s very fun and not an easy track to be fast at.
The track’s conditions will change from race to race. There may be bad weather or excess debris, called marbles, from earlier races. Generally, however, the strategy from the last race, if it was a good one, will work for the next race. Once you know a track, you know it forever.
Investors aren’t so lucky. Markets change every day as new data is disseminated and digested. We really don’t know how markets will behave. We have no map for what will happen next.
Of course, we investors have tons of data. And we can use that data to help model the market and see what other investors are thinking and doing.
I’m a big fan of sentiment analysis. I believe that everything in investing is sentiment. You see, investors swing between optimism and pessimism. When investors are optimistic, they are excited about the future and believe that they are smart and that their investments will rise in value. They’re willing to pay exorbitant prices for stocks (like Tesla) and the stocks trade for more than fair value. Sometimes, they’re right! When investors are wrong, they become pessimistic. They believe they’re always wrong. They panic and sell their investments. The stocks trade for less than fair value.
My favorite map of the market is the Cycle of Investor Emotions. It’s purely theoretical but if you’re like me, you can remember times that you were optimistic and pessimistic.
https://russellinvestments.com/us/resources/individuals/cycle-of-investor-emotions
The point is, when we’re at our most euphoric, our investments’ valuations are often stretched and future returns are probably going to be poor. When we’re despondent, valuations are low and it’s probably a great time to buy.
Markets are discounting mechanisms. We anticipate the future. We, as investors, will buy stocks that we think are going to increase in value and sell those we think will decrease. We try act before the news comes out. In fact, economists use the S&P 500 stock market index as a leading indicator of economic health.
The Cycle of Market Emotions is a nice visual. But it’s not a market timing device. Sadly, there’s no such thing. You see, we can measure when investors are optimistic and pessimistic, but we can’t know when they’ll change their minds!
We can, however, use data to understand where investors are within the cycle. I like market based sentiment indicators like the CNN Business Fear & Greed Index. There are others, and Ned Davis Research produces some of the best, which they sell to institutional investors. But CNN’s Fear & Greed is free and does a very nice job. I know of professional analysts who use it to help their clients manage large sums of money.
Fear & Greed measures investor optimism and pessimism. It’s not a trading system! These types of indicators are used to help us understand whether investors have been actively buying or selling. If they’ve bought too much, and too fast, the market is due for a pause or correction. Essentially, we’re measuring investor activity in order to understand when investors have overdone it.
Here’s a historical chart created by Fidelity’s Jurien Timmer that overlays CNN’s Fear & Greed Index on the S&P 500.
https://twitter.com/TimmerFidelity
Again, not a trading system. But it’s a great view into what emotion is driving investor behavior.
Great! Investor sentiment indicators like Fear & Greed provide a roadmap that we can follow. It’s not a complete map but it’s an important component of our map. As I said earlier, everything in investing is sentiment and we should consider all of our analyses from this perspective.
With that in mind, how should we act during periods when investor emotions are extreme? Well, that depends on what type of market participant you are!
If you’re an investor, you should already have a long-term plan that is based on your preferred asset allocation. If that’s the case, then, maybe, you do nothing at these extremes. One financial advisor I know uses CNN’s Fear & Greed as a behavioral tool. When the market declines and his clients are afraid, he reassures them by saying that other investors are fearful too. His clients then realize that emotional extremes are cyclical and that selling when investors are already fearful is rarely wise. In some cases, he even talks his clients into using the volatility to buy more risky assets, like stocks. Emotional extremes often coincide with opportunities to change your asset allocation.
If you’re a speculator, market sentiment can be an important part of your analysis. For one thing, you might consider trading along with the crowd. This is how some hedge funds called trend followers make their money. Other traders, called contrarians, look for extremes in market sentiment and take the opposite side. They buy into extreme fear and sell when the market hits extreme greed. Both strategies can work if you’re willing to watch the market closely. (not investing advice!)
Another important question to ask as we map the market is how stocks behave when the market is more fearful or more greedy. In my own research into sentiment analysis, I’ve noticed that when investors are most fearful, stock market volatility spikes. Without getting into too many statistics, this means that the market has bigger up and down days near a market bottom than near a market top. Less risky assets, like bonds, often jump in price, too, as investors sell the risky stuff to save their wealth.
There are also different types of tops and bottoms. Major tops often take a year or more to form as investors throw good money after bad, thinking that they’re getting their stocks on sale. Bottoms may look more like a V as those same investors capitulate all at once, either because they’re scared or because they borrowed to buy those stocks and their broker is selling them out to protect their own capital and employees.
One of the recurring themes of Pacenotes is that racing drivers have a plan. Rally drivers map their route in advance and use a navigator to read the notes during the race. F1 drivers and other circuit racers map the track so that they know the best line to take through each corner. They plan their race in advance so that it’s easier to execute during the race.
Investors should do the same. Make a plan, work the plan. Market sentiment indicators like CNN’s Fear & Greed can help investors to manage their own emotions and to make better decisions so that they can stick more closely to their plan.
Thank you for reading and happy holidays!
Jason