What Is Market Sentiment? Definition, Indicator Types, and Example

Market sentiment is the current attitude of investors overall regarding a company, a sector, or the financial market as a whole. The mood of the market is affected by crowd psychology. It is revealed through buying and selling activity.

In broad terms, rising prices reveal bullish market sentiment, while falling prices indicate bearish market sentiment.

Understanding Market Sentiment

Market sentiment, sometimes called investor sentiment, does not correlate to fundamental changes in the market. Day traders and technical analysts rely on measurements of market sentiment since it influences the indicators used to measure and profit from short-term price moves caused by the crowd psychology of active investors.

Market sentiment is also important for contrarian investors who trade in the opposite direction of the prevailing consensus. For example, if everyone is buying a stock, a contrarian would sell it in order to profit from the move upwards.

Market sentiment is often described as either bearish or bullish. When the mood is bearish, prices are going down. When it's bullish, stock prices are going up.

Emotion often drives the stock market, so market sentiment is not related to the fundamental value of a stock. Changes in prices occur for many reasons beyond what a fundamental analysis would deduce.

Market sentiment demonstrates broad concerns, expectations, and emotions about the market, while fundamental value is about real business performance.

Indicators of Market Sentiment

Many investors profit by buying stocks that are wrongly valued due to market sentiment. They use several indicators to measure market sentiment to help them determine the best stocks to trade, including the CBOE Volatility Index (VIX), the high-low index, the bullish percent index (BPI), and moving averages.

The VIX

The VIX, also known as the fear index, is driven by option prices. A crucial tool for traders, the VIX indicates the expected volatility of the S&P 500 index.

High VIX levels can signal heightened worries, potentially a signal of a market bottom. A low VIX can suggest market complacency and is seen as a clue that a market may have peaked.

The High-Low Index

The high-low index compares the number of stocks that have reached 52-week highs to the number of stocks that are at 52-week lows.

When the index is below 30, stock prices are trading near their lows, and investors have a bearish market sentiment. When the index is above 70, stock prices are trading near their highs, and investors are bullish.

Traders typically apply the indicator to a specific index, such as the S&P 500 or Nasdaq 100.

Bullish Percent Index

Based on point and figure charts, the BPI measures the number of stocks with bullish patterns.

Neutral markets have a bullish percentage of about 50%. When the BPI reads 70% or higher, market sentiment is extremely optimistic, which could signal that stocks are overpriced.

When it measures 30% or below, market sentiment is negative, indicating an oversold market.

Moving Averages

Investors typically use the 50-day moving average (MA) and 200-day MA when determining a market’s sentiment.

When the 50-day MA crosses the 200-day MA from below it is called the “golden cross." This indicates that momentum has shifted to the upside, creating bullish sentiment.

When the 50-day MA crosses below the 200-day MA, this is called the “death cross." It suggests lower prices and bearish sentiment.

The Limits of Using Market Sentiment

Though a handy tool in financial markets, market sentiment has limitations. The herd mentality is swayed most easily by fear and greed. It is not necessarily a reaction to the fundamentals of a stock or a market.

Moreover, short-term news, events, worries, and even rumors can sway market sentiment, especially in fast-paced, high-liquidity markets. When everyone's riding a wave of optimism, it might mean a peak is coming, and the opposite is true when investors are in a doom-and-gloom mood. As a result, irrational market sentiment can lead to greater market volatility.

Remember that the data on sentiment can be a bit of a wild card. Surveys, social media, and news reactions can be all over the map. This makes it a challenge to pinpoint and interpret whether the underlying information is misleading or outright wrong.

It's important to keep in mind that market sentiment is like a sprinter in short-term trading but not much of a marathon runner. If you're in it for the long haul, it's more productive to think about the big picture and diversify your portfolio.

Real World Examples of Market Sentiment

An uncertain economic outlook often leads to wild swings in the stock market between bullish and bearish sentiments. We can use an example from the early 2020s. As you can see in the chart below, fear picked up among equity investors at various points throughout 2022, leading to intraday volatility in the S&P 500 not seen since the Great Recession of 2008.

High inflation and the response of central banks were likely to blame. In the traditional economic cycle, when interest rates start rising significantly, it’s only a matter of time before the impact of higher borrowing costs causes a recession.

Many investors grew alarmed that the economy was about to crash and started selling. However, a handful of others sought to capitalize on these jitters, thinking a recession would be averted. Gradually, the economic doom and gloom subsided.

Market Sentiment in 2023

In 2023, economists grew increasingly confident that the year would not end in recession despite earlier worries. Market participants, keen to profit from equity markets priced to reflect an economic meltdown, quickly turned bullish. The S&P 500 began its ascent again, and the VIX gradually dropped.

By September 2023, volatility, as measured by the VIX, was at a three-year low. That suggests nerves grew calmer.

Economic sentiment will shift again at some point. Over time, as economic conditions evolve, analysts and investors adjust their outlooks. When the market starts to price in extreme scenarios, like an economic meltdown, sentiment can quickly turn bullish at the sight of any positive economic data.

Market sentiment is inherently sensitive and can change rapidly. After a period of optimism, when valuation multiples reflect a positive outlook, the market becomes vulnerable. Even minor negative news can shift the mood, turning bullish investors bearish again.

The Bottom Line

Market sentiment is an example of crowd psychology. Optimism or pessimism grows and spreads as many market participants respond to the latest news, rumors, or projections.

Generally, rising prices indicate bullish market sentiment, while falling prices indicate bearish market sentiment.

The long-term investor would be wise to stay above the fray. When the bears are in charge, the bulls are just resting.