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Last Saturday I spoke at the UK Investor Show about the importance of sentiment on stock prices. Each time I present on this subject I am not sure if the audience connects with the notion that “stock prices are driven by sentiment”. This is not conventional wisdom as the majority of people who invest in the stock market use traditional and tangible measures of valuation like P/E ratios or cash flows, they generally believe stock prices are driven by fundamental factors alone.
And yes if we look at the long term trend of the stock market this would seem to be an accurate assumption. Historically the stock market has risen because companies grow their earnings, however short term prices are not driven by fundamental factors, in fact their prime influence is sentiment and I have the proof to back this statement up. When I started my career I studied fundamental analysis and passed the Investment Management Certificate but my passion was with charts. I believed that the stock market followed a cycle and by analysing past patterns I could develop the knowledge to predict its future direction.
What I did not know at the time was that sentiment played a big part in the direction of the stock market. Fast forward many years later and I decided to undertake some research on the subject – the results confirmed my short term sentiment driver theory. In 2013 I recorded all the ‘tips’ issued by the Investors Chronicle (stocks with a market cap over £500m) between December 2010 and February 2013. The objective was to monitor each ‘tip’ during periods when my sentiment indicator (ESI) was bearish and periods when the ESI was bullish. The Investors Chronicle has a good track record over the long term, their ‘tips of the year’ have beaten the FTSE 100 nearly every year. However in the short term their tips fail to perform when my sentiment indicator is not favourable.
In other words buy recommendations failed to perform during periods in which the ESI was bearish and sell recommendations failed to perform during periods in which the ESI was bullish.
Here are the results from my research:
ESI = bullish, IC buy recommendations, average performance per tip = +3.9%
(If you followed the tip and bought the stock you would be up 3.9%)
ESI = bullish, IC sell recommendations, average performance per tip = +2.5%
(If you followed the tip and sold the stock you would have missed gains of 2.5%)
ESI = bearish, IC buy recommendations, average performance per tip = -4.0%
(If you followed the tip and bought the stock you would be down 4%)
ESI = bearish, IC sell recommendations, average performance per tip = -5.1%
(If you followed the tip and sold the stock you would have avoid losses of 5.1%)
In conclusion, when sentiment is bullish most of the Investors Chronicle tips, whether buy or sell will go up, and when sentiment is bearish a large proportion of their tips will go down.
This is why I believe sentiment is a powerful tool to forecast the stock market, given the positive results and with this new approach in mind, I will now give more credence to sentiment analysis in my investment strategy model.
Take the recent sharp sell-off in the stock market, this was not surprising when considering sentiment analysis. I have warned of a potential top in the FTSE since April last year and so far I have been proven right, the FTSE is still trading below the high set in May 2013. I have written numerous articles on why the FTSE 100 is about to enter a bear market – ok the bear market has not yet started but it’s just a matter of time. Furthermore the behaviour of the FTSE relative to the S&P is ominous. I have discovered that when investor sentiment reaches an extreme in optimism and the FTSE is not following the S&P higher, the FTSE is said to be leading the way. Under current market circumstances I expect the FTSE to turn down and lead the S&P into the next bear market.
At the UK Investor Show I explained why this could happen soon. This is the chart I presented to the audience:
The first signal came toward the end of February when the FTSE failed to break above the previous high while the S&P made a new high. At that time sentiment was bullish but the 13-day BTI was above 400. A reading above 400 in general occurs prior to the start of a stock market correction. It is also a contrary sign that bullish sentiment will turn bearish and this is exactly what happened, on 12 March the FTSE turned down and sentiment turned bearish. A day later saw the FTSE oversold and the 13-day BTI below -400. In this situation and despite the bearish sentiment the strategy is to go long because a reading below -400 is the opposite of a reading above 400 so the chances are the FTSE will bounce back. This bounce which is accompanied by continued bearish sentiment can be classified as a counter-trend rally.
Last week the counter-trend rally from the March low hit a high of 6706, this level could mark the end of the bounce. With sentiment failing to turn bullish and the market falling sharply from those highs means failure of the FTSE to break above 6706 will have further negative effect on sentimentand the stock market will soon turn bearish again.
Thierry Laduguie is FTSE 100 Trading Strategist at www.e-yield.com
