Economics Investing

Sentiment

Sentiment is one of the main drivers of stock prices in the short, medium and long-terms. Understanding sentiment and how it contributes to stock price movements and returns is imperative for all would be investors.

Short-term sentiment is what drives the action in stock prices day in and day out. Think of the recent negative sentiment that has arisen as a result of a potential trade war and potential military conflict in the Middle East. These types of events are generally transitory and don’t have lasting impacts on sentiment because they won’t actually impact underlying fundamentals until they go from being potential to actual. Of course, everyone attempts to determine the probability of going from potential to actual, which also contributes to daily and weekly stock market gyrations.

Medium- and long-term sentiment drive the stock market over the course of months and years. These sentiments tend to be more grounded in the actual drivers of stock price performance, namely economic growth, earnings growth, supply/demand, etc… For example, medium-/long-term sentiment currently appears to be grounded in a global growth story with earnings in the US expected to accelerate in 2018. As a result of the expected growth, interest rates are generally expected to rise and stock prices are expected to continue to rise in spite of elevated valuations.

As a reminder, elevated valuations don’t mean a crash is imminent. They simply imply there is greater downside risk to medium/longer-term returns. Besides, everyone knows valuations are elevated right now. Another catalyst, such as deteriorating economic and/or company fundamentals, would likely need to surface to lead to an inflection point in longer-term sentiment and trend.

In the meantime, there is quite a bit of uncertainty right now and sentiment is all over the place. The market appears to be waiting for confirmation, one way or the other, to determine its path forward. For example, if earnings expectations come in as expected, short-term sentiment will likely turn more positive and the longer-term sentiment trend would be confirmed for now although there is some risk of a sell the news mentality. If earnings  and outlooks disappoint, then we may be at or nearing an inflection point in the longer-term sentiment trend. Nobody knows with certainty. Only time will tell.

Finally, the chart below provides a good visual example of short-term vs. long-term sentiment.

TD Ameritrade’s  retail investor sentiment index (green line) has decisively weakened to start the year off (short-term sentiment). Notice how the S&P 500 index (gray line) has come off in conjunction with the short-term sentiment indicator. Also notice how the S&P 500 remains in an uptrend (longer-term sentiment) in spite of the negative retail investor sentiment.

From my perspective, the short-term negative sentiment could potentially be a positive sign for the market in the near-term as non-drivers of stock returns (potential trade war and potential military conflict) may have been overly discounted into stock prices at the expense of the actual drivers of stock returns (i.e., earnings growth).