The Challenge of Measuring Investor Sentiment

By on November 29, 2010

Derek Hernquist, writer of a blog entitled, “Musings of a tape reader,” recently examined the problems behind measuring investor’s emotions. 

The goal of converting sentiment into profits has eluded most, if not all, self-dubbed contrarians. Of course we all “know” that if everyone is bullish, there is no one left to buy…if everyone is bearish, there is no one left to sell. But dissect those sentences, and you find far more questions than answers. How do we define “know”? What % equates to “everyone”? How do we measure whether someone is bullish or bearish? And even if they are, is there not a chance they will cave to performance pressure if their opinion was early?

Hernquist looks at the traditional sentiment indicators such as the Put/Call Ratio, VIX, Breadth Surge/Plunge, and Bull/Bear Polls, and the limitations of each.  He also highlights some new tools available for the sentiment reader, but points out that these have their own challenges:

We are seeing more interest in using Google and Twitter trends to measure what has grabbed the attention of the public. At the end of the day, however, using sentiment comes down to the decision maker. Without a way to interpret the data and apply it in the right timeframe, it becomes one more piece of noise to cloud our planning and execution.

Hernquist settles on range and volume as the best sentiment indicator:

Why not use good old fashioned volume and range to identify emotion? Many have tossed aside volume because it tests so poorly. But that’s because the largest volume spikes occur at breakouts and exhaustions…totally different structures that require one data set for “early” volume and one for “late”.

At least abnormal volume and/or range occur frequently enough that we can live through a larger sample size in developing our ability to interpret emotional extremes. Not only that, but instead of focusing on a few indices, we can apply our findings to the entire universe of stocks in order to discover more and better opportunities.

It’s as simple as this…average volume and average range imply the (rational) continuation of the recent phase. Unusual volume or unusual range, be they larger or smaller than normal, imply the presence of emotion. Large volume means new information, someone is caught off guard and feels the need to adjust. Large range means the prevailing range wasn’t wide enough to facilitate normal trading…this can mean new and important information, or that someone felt panicked and rushed to act beyond the typical range. The first instance should have persistence, the second will be fleeting. Narrow range might mean anxiety…this builds energy for an outsized move once marginal buyers and/or sellers decide to act.

Source: DerekHernquist.com
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