By Tony Finding
The S&P500 index has risen to near record levels, but it seems that this has happened without any apparent rise in optimism about future corporate prospects. If anything, judging by my inbox, the chorus of impending doom gets louder by the day. The concurrent rise in the S&P500 with this gloom seems somewhat paradoxical.
Looking more closely at market sentiment can help us improve our understanding of the nature of risk pricing today. Market sentiment can be thought of as the aggregated mix of investors’ emotional states at any point in time. It manifests itself in the tone of the market. It therefore differs from pure technical analysis which concerns itself only with the study of past price patterns.
In the old days gauging market sentiment largely consisted of seeing which way the weathervane was pointing in the press and tracking such things as momentum, trading volumes, option pricing and perhaps eyeballing the occasional investor survey. Today it has become rocket science.
Quite staggering progress has been made over the last decade in the use of technology for sentiment analysis, with many systems now utilising sophisticated analytical software that applies language processing techniques to multiple news feeds and social media platforms. While certainly not infallible, the increasing use of algorithms and predictive analytics through such channels may be making asset markets much more rapid in responding to news in the very short run, but that does not imply that we won’t continue to persist in certain sentiment regimes for extended periods of time as has often happened in the past. These sentiment regimes are important for investors because they affect our collective decision-making and will influence how the market reacts to news.
The way that asset prices respond to new information is dependent on how the asset is priced in valuation terms and on the sentiment regime. Valuation informs us how investment risk is priced while market sentiment impacts the degree to which investors in aggregate will respond to new information. Perceptions of downside risks are much higher when we are in a pessimistic sentiment regime like we are today than they are in a more optimistic one.
The implications of this for the stock market as a whole is that in today’s negative sentiment regime, it seems likely that investors are somewhat reluctant to immediately discount positive news because it presents an awkward contradiction to their own beliefs. Such under-reactions to new information help explain why markets can trend for such long periods of time. Similarly, in an optimistic sentiment regime investors are somewhat reluctant to discount negative news for related psychological reasons.
So what has been influencing our collective mood and dampening our collective optimism? While it is impossible to know for sure, it may be the case that a negative emphasis in the media combined with distressing images of regional conflict in the news is doing little to help our fragile emotions that are already haunted from recurrent bouts of traumatic volatility in risk assets in recent years. With this in mind, let’s return to the issue of near record US stock prices with widespread pessimism.
Rather than being pumped up by easy money as many believe, the performance of the S&P500 may in part reflect a lagged response to a significant increase in aggregate stock market profits since the great financial crisis.
If this rise in profits has indeed contradicted many investors’ pessimism about the medium-term then the good profits news will not have been interpreted dispassionately in this negative sentiment regime. This information would likely be discounted slowly as investors have held on to a negative outlook in the face of positive surprises.
The time it takes for sentiment to shift in the face of the evidence is one of the reasons why price trends occur. This internal tension we feel as humans when our cherished beliefs are challenged has a fancy label in behavioural psychology; it is called cognitive dissonance. Looked at this way, cognitive dissonance goes a long way to explaining why record levels on the S&P500 are occurring alongside such widespread negative sentiment.
It would be unusual for a bull market to end when there is so much apparent pessimism, we may not be in a bull market despite rising prices. Perhaps a true bull market requires not only rising prices but also a shift from a pessimistic to an optimistic sentiment regime. What could cause this to happen? Given the role that price feedback effects can have on our mood, an upward lurch in stock prices from here could powerfully change how investors feel about risk, leading to a set of conditions closer to the equity bull markets of the past. Sentiment could also change simply because investors come to believe that low interest rates may in fact be fully consistent with reasonable profit outcomes.
I admit, at the moment this feels very unlikely, but I too share many of the anxieties that others do concerning the outlook for the global economy. This is probably a reflection that we remain mired in a pessimistic sentiment regime but it would be unwise to assume that this will persist indefinitely.