A New Market Sentiment Indicator
The cyclical nature of equities trading is one of the eternal truths of the financial markets, with bull and bear markets having been empirically documented for more than 100 years. Charles Dow,1 co-founder of The Wall Street Journal and a pioneer in technical analysis, compared market movements to ocean waves influenced by tides. Value-investing legend Benjamin Graham2 took a different approach, one emphasizing fundamental analysis. Graham believed that his fundamental approach would be rewarded in the long run, because mispriced securities would ultimately revert back to their fair values. As he so eloquently characterized it, “The market is a pendulum that forever swings between unsustainable optimism and unjustified pessimism.” The emerging field of behavioral finance supports Graham’s point of view, providing a strong theoretical foundation for the overreaction bias that is often a driving factor in cyclical markets.
One of the fascinating aspects of market cyclicality is its fundamental relationship to risk and return. Figure 1 shows realized investor returns over the past 20 years compared with the performance of a wide variety of indicators. The astonishing result is that the average investor badly underperforms across the board because he or she is prone to chasing performance near market tops and panicking near market bottoms. For this reason, an effective measure of market sentiment may be of significant value in navigating risk and enhancing returns. The purpose of this paper is to introduce the Acertus Market Sentiment Indicator (AMSI), which is designed to provide an enhanced means of assessing market behavior, and to discuss how it may add value to the investment process.
The Purpose Of The AMSI, A New Multifactor Sentiment Index
While no one can predict the future, it is important for investors to understand where we are today and to be able to view current conditions in a historical context. The purpose of any index or an indicator is to measure the current level of something. There is a formidable list of indicators for a range of market conditions, and, when appropriately constructed and widely followed, they have the potential to add value when important investment decisions are being made.
We chose to focus on constructing an indicator of “market sentiment,” which, in conjunction with its component parts, can provide important insight into current investor behavior and place it within a historical context. Understanding investor behavior becomes particularly important during the cyclical phases of markets, especially during market extremes. “Sentiment” refers to a feeling, emotion or attitude about something, and, of course, it can have a range of values. With respect to financial markets, fear represents one extreme, while greed represents the other end of the spectrum. We view sentiment as a continuum, with anxiety and complacency representing less extreme and nuanced forms of fear and greed, respectively. In sharply rising markets and near market tops, greed and overreaching clearly come into play, but the authors believe that complacency is the more insidious and potentially destructive sentiment because it can lead investors into a failure to manage and monitor risk.
Reference.com defines complacency as “… a feeling of quiet pleasure or security, often while unaware of some potential danger, defect, or the like; self-satisfaction or smug satisfaction with an existing situation, condition.”4 Rather than the excessive desire for wealth that characterizes greed, we believe that being unaware of dangers accurately describes the reason for many investor losses. “Anxiety” represents a less extreme form of fear that corresponds to distress or a lack of peace of mind. Mild to moderate investment losses cause most investors anxiety, but do not necessarily drive them toward abject fear. Figure 2 expresses this range of investor emotions in the context of Graham’s pendulum analogy.