The Extra Edge: Sentiment is the Missing Link in Equity Analysis

The following article, written by Bernie Schaeffer and Bob Kraft, is from the spring 2009 issue of SENTIMENT magazine, which is designed specifically for those interested in trading options. Every issue of SENTIMENT includes educational pieces for newcomers to options trading, as well as advanced strategy stories to help experienced traders build their portfolios. Please click here if you would like to receive your own copy of the next quarterly issue of SENTIMENT.

The slightest edge. That's what every trader looks for—something that uncovers market opportunities that others aren't seeing.

Traders and investors have long analyzed price charts and pored over company financials in search of that elusive edge that might help them time the market or discover a hidden gem. But by themselves, charts and financials tell only part of the story. All too often they exist in a vacuum as millions of other traders and investors collectively interpret the same data, ultimately drawing conclusions that tend to differ from one market to the next. In essence, they're like a two-legged stool: it just won't stand up very well on its own.

So what's missing? Investor sentiment. More specifically, the measure of the collective "mood" of the markets using sentiment analysis. When the three elements of fundamental, technical, and sentiment analysis converge, a much clearer picture can be drawn about market opportunities. It's this three-tiered principle that has evolved into the methodology we call Expectational Analysis® (Figure 1).

What exactly is Expectational Analysis, and how does it apply to the stock market? First, let's elaborate more on its three components:

Fundamental analysis deals with the financial health of a company, including factors like earnings, dividends, price-to-earnings (P/E) ratios, and broader projections of the strength of the economy.

Technical analysis focuses on historical price patterns, volume characteristics, trends, and quantitative analysis in order to predict future price movements.

Sentiment analysis is a clear-eyed dissection and study of the beliefs and convictions of the market.

Sentiment -- The Missing Link

So why is sentiment analysis so important? Investor sentiment is the collective feelings, moods, beliefs (and in some cases, actions) of investors, from the smallest individual investor to the supposed "smart money" of institutions. The most accurate sentiment indicators generally reflect what a group of investors is actually doing as opposed to what they're feeling and saying, although the latter also has a degree of validity.

Sentiment analysis tells us what investors and traders are expecting out of a stock, a sector, or the market as a whole.

Why are expectations so important? Because the price of a stock represents investors' perceptions of reality, and these perceptions are often excellent contrary indicators. A stock with relatively low expectations stands a good chance of rallying as traders react favorably to any news developments that might remotely be considered positive. Conversely, high expectations can put downward pressure on a stock if traders are discouraged by news that falls short of perfection. You've probably seen this phenomenon time and again during earnings season, when a stock is reported to have declined in price "despite announcing record earnings."

Put another way, low expectations translate into potential buying power as skeptical investors (and their investing capital) wait on the sidelines, ready to bolster a stock's appreciation by buying up the supply from profit-takers. This excess demand drives the price even higher. On the other hand, high expectations usually mean that much of the sideline money has already been committed to a stock. Buyers are now scarce, and selling will predominate on any perceived negative news, leaving the stock more vulnerable to a significant decline.

One extremely important cautionary note: Expectational Analysis investing does not mean blindly buying a stock or index just because no one else likes it. It should be expected that negative sentiment would surround a poorly performing security. Remember, if a stock has been declining, there is probably a reason. Negative sentiment alone is not enough to predict that a stock will go back up. Negative sentiment only tells us how much potential buying power might be available if we expect a recovery in the stock.

The Crux of Contrarian Investing

One of the most important tenets of the Expectational Analysis approach is that the power of a contrarian indicator is much greater when the underlying sentiment runs counter to the direction of the stock.

For example, pessimism would be an expected reaction to a down-trending market and would therefore not be a valuable contrary indicator. On the other hand, skepticism in a rising market is a powerfully bullish combination, as market tops are not seen until optimism reaches extreme levels. Investors are normally quite bullish during bull markets and quite complacent and relatively lacking in fear on pullbacks in bull markets. It becomes an art for the sentiment analyst to determine when this bullish sentiment has reached an extreme, at which point buying power will have become dissipated to such an extent that the market will top out.

But when negative sentiment accompanies a bull market, the task of the "sentimentician" becomes much easier. It becomes clear that buying power has not yet dissipated and that the bull market has farther to run before potentially topping out. And this is why sentiment analysis can be such a valuable adjunct to technical analysis. Stock A and Stock B might each have very attractive charts that would indicate a bull market to a technician who might be looking to buy pullbacks. If sentiment on Stock A is "over the top" bullish, buying pullbacks might be a prelude to disaster, because sideline buying power could be seriously depleted. But if there is strong evidence of bearish sentiment on Stock B, you can be a lot more confident that the stock will be supported on pullbacks by sideline money eager to participate in the next rally.

That, in a nutshell, is what Expectational Analysis is all about. We look for potential buying and selling opportunities by gauging investor expectations. In other words, we believe that by the time it becomes public knowledge that a large number of people are "bullish" on a particular stock, a substantial amount of that stock has already been bought, and there might not be much additional demand. This depleted buying strength is then more likely to be overwhelmed by even a small amount of selling pressure, which will push the stock lower. Similarly, for a weak stock on which "everyone is bearish," the selling power has been mostly depleted. Even a small amount of buying may begin to push the stock higher.

How to Apply It All to the Stock Market

In the context of contrarian investing, it's instructive to consider the various stages of a stock's cycle during a bull market rally or a bear market decline. As market participants progress through these four stages (which are often trumpeted in the financial media), the chances for a reversal in the trend increases.

Following are the four stages of sentiment underlying the transition from a bear to bull market (see Figure 2):

Despair—At a market bottom, there is an overwhelming sense of despair. Investors are hopeless, and magazine covers are proclaiming the worst. An old adage says the night is darkest before the dawn. This theory holds true with the stock market, as a firm bottom based on desperation and hopelessness must be in place before a true recovery can begin. The fear and panic indicate that selling pressure has been decimated and that the last bullish investor standing is about to turn out the lights.

Disbelief—During the initial advance from a major market bottom, there is a sense of disbelief until the rally proves itself. For example, disbelief was the overwhelming emotion in 2003 when technology stocks began to rally from the depths. This disbelief, or wariness, is often manifested by a continued preponderance of short selling or an absence of call buying, even when the market has shown considerable strength. This disbelief is a strong indication that there is ample sideline money available to push the market higher.

Acceptance—The middle stages of the rally spur a sense of acceptance among market participants as investors begin to believe that a bull market is possible. The middle stage of a market rally constitutes a trend, and the public is right in accepting it.

Euphoria—Euphoria is the final stage and is generally cause for concern, as too much optimistic sentiment tends to precede the end of a market rally. If everyone is euphoric, and putting as much capital as possible into the market, then there isn't much left on the sidelines to continue propelling the market higher. It is at this point when the bull market will ultimately do an about-face and begin to retreat. In other words, by the time the weaker hands are invested, the market becomes most vulnerable.

Remember that the same stages hold true when a bull market morphs into a bear market. Euphoria (seen at the top) evolves into disbelief of any pullbacks, as investors cling to the shadow of a bull market even when the technical picture shows otherwise. Before a bottom is reached, marked by despair among investors, there will be a general feeling of acceptance of the decline, as market participants scurry to protect their portfolios from the inevitability of bear-market drawdowns.

Investor sentiment will reach extremes at market tops and market bottoms, but picking tops and bottoms is not nearly as easy as it might seem. The problem with picking bottoms is that "gloomy" can always get "gloomier," and for those trying to pick tops, "irrational exuberance" is often followed by "insane exuberance." The greatest value of sentiment analysis for the trader or investor is in determining those situations where sentiment is going against the price action and the fundamentals, in which case you can have a high degree of confidence that the prevailing trend will continue. Expectational Analysis can help get you in and out of trends early, giving you that edge you've been looking for.