Estimating Market Sentiment With Market Prices

Investor sentiment is a slippery beast, but a valuable one – if you can find reliable data. Knowing that the crowd is in a state of irrational exuberance, or hopeless despair, is especially useful. Nothing strengthens confidence like market extremes when it comes to estimating expected return and risk. But there’s that data issue to consider.

Sentiment polling is the standard approach. There’s worthwhile insight here, or at least there can be at times. But there’s also a distinct set of pros and cons. On the latter, the numbers may not be timely or precise. That doesn’t mean you should ignore conventional sentiment numbers, but there’s no reason not to supplement that data with other methodologies.

One possibility is using a ratio of moving averages as a proxy for sentiment. As a quick test, let’s compare the 50-day moving average to 200-day average as a rough approximation of animal spirits. We’ll use a set of ETFs to represent the major asset classes.

The assumption here is that the degree of divergence in the 50-day vs. 200-day average offers an approximation of bullish vs. bearish sentiment. Most of the time the readings will be relatively middling. When they’re not, there’s potentially valuable information to consider.

As a simple test, the chart below compares this definition of sentiment for three equity market buckets: US stocks (VTI), foreign stocks in developed markets (VEA), and shares in emerging markets (VWO). The main takeaway, sentiment is unusually bullish at the moment, at least relative to market history since 2013.

For example, Vanguard FTSE Emerging Markets (VWO) has the highest reading: 1.15, which means that that VWO’s 50-day average is about 15% above its 200-day average. Note, too, that sentiment between the three equity funds tends to be highly correlated, which suggests that there may be relatively compelling opportunities when the ratios diverge.

For another spin, the next chart compares sentiment for US stocks (VTI), US bonds (BND), and US real estate investment trusts (VNQ). In this case, the sentiment variations exhibit far more independence, as you would expect in different asset classes.

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Disclosure: None.

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