What Is Sentiment?

Sentiment is defined as the net amount of any group of market players’ optimism or pessimism reflected in any asset or market price at a particular time. When a stock or commodity is trading at a price considerably above or below its intrinsic value, something we will not know until considerably later, the difference or deviation from that value often will be accounted for by sentiment. It is the collective emotion and other intangible factors that come from the human interaction involved in determining a price over or under the supposed value. It is the subject of study by behavioral finance departments, which are interested in the ways that human cognitive bias and brain activity affect financial decisions. It is also a staple in technical analysis, for technical analysts have long held that prices are a combination of fact and emotion. When emotion becomes excessive and prices thereby deviate substantially from the norm, a price reversal is usually due, a reversion at least to the mean and sometimes beyond. It is, thus, important for the technical analyst to know when prices are reflecting emotional extremes.

Box 7.1 The Theory of Contrarian Investing

Whenever nonprofessional investors become “significantly” one sided in their expectations about the future course of stock prices, the market will move in the direction opposite to that which is anticipated by the masses.

Suppose the overwhelming numbers of investors (call them nonprofessionals) become rampantly bullish on the market. The logical extension of highly bullish expectations results in the purchase of stocks right up to the respective financial limits of the masses. At the very moment when the masses become most bullish, they will be very nearly fully invested! They won’t have the financial capacity to do more buying. Who then is left to create demand? Certainly not the minority of investors we call professionals. It is that group that recognizes over-valuations and presumably has been the supplier of stock to the nonprofessionals during the time that both prices and the optimism of the masses were rising.

Thus, when the crowd has become extraordinarily bullish, a dearth of demand exists. The nonprofessionals are loaded with stocks and are cash-poor, whereas the professionals are liquid but in no frame to buy. Demand is saturated, and even minor increases in supply will cause stock prices to tumble. At this point, prices are a strong bet to go (nowhere) but down (Marty Zweig in the foreword to Ned Davis’ The Triumph of Contrarian Investing, McGraw- Hill, New York, 2003).

Source: Kirkpatrick II Charles D., Dahlquist Julie R. (2015), Technical Analysis: The Complete Resource for Financial Market Technicians, FT Press; 3rd edition.

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