As you pour the milk into your coffee, it spreads evenly into your cup, from the center out. It's unlikely that all the cream will end up on one side. Any one molecule's "trip" is completely arbitrary; as a group, however, they distribute themselves evenly.
At SentiTrade, we look at financial news in a similar way; under normal circumstances, bullish and bearish market news spread into a large market psychology mix. However, unlike the milk and coffee example, there are sometimes situations when a particular news story completely distorts the market.
A bearish trend can continue simply because investors expect (or fear) that it will. They follow it simply because they believe others will too. This type of momentum trading has nothing to do with rational pricing of the market and does not fit the description of efficiency oriented investors.
It is, however, "human," and by reading this week's news, investors get a picture which is almost completely black. Still, a bearish sentiment cannot continue its dominance of the market psychology indefinitely. The question is when and how we can identify a market psychology turning point.
SentiTrade first scans information from an aggregate of validated financial news sources. Next, we determine whether the information is positive or negative. Finally, the ratio between positive and negative news is calculated, converting market sentiment into specific number values. To identify whether a bearish trend is nearing an end, or whether it will continue, we study historical movements in market psychology.
Just as with certain market price levels, there are areas of support and resistance in market psychology too. No one will be surprised to learn that we currently have a market sentiment which is decidedly more black than average. Due to the crisis in Europe, there are clearly more bearish financial news stories than normal.
Looking at the 38/200 day moving average calculation of positive vs. negative news stories, we see a downward momentum trend going back to July of 2011:
Currently the gap between the 38 and 200 line widening, but historically, the divergence was far greater in October last year. Also, the speed at which the sentiment swings from bullish to bearish, and back again, i.e. sentiment volatility, has exploded the past two weeks.
As opposed to the volatility calculation of the market, applying an implicit approach, we measure historical volatility of market sentiment. A simplified way of explaining the difference, is to say that the implicit calculation accounts for the expected volatility which occurs when future contracts are about to expire. Our approach is to compare the historical range of positive vs. negative financial news stories, to the current market news situation.
The volatility sentiment quotient (V-SQ) can then be used to assess market psychology. High levels of sentiment volatility means that positive and negative financial news stories continually contradict one another, adding to market nervousness. Accordingly, the current V-SQ reading confirms of the bearish outlook.
Comparing the current market psychology to the situation around Lehman, we see that things may get a lot worse before they get any better (check our moving average and volatility readings from 2005 to 2012). Recall the market collapse following the initial Tarp rejection by Congress in 2008; a sudden fall of 10-15% on the DAX may be needed to force some action in the euro zone too.
The SentiTrade market psychology data is used to trade the DOW and DAX index futures. With a negative market sentiment momentum, high V-SQ levels and a widening gap between the 38/200 moving average, we see a good potential for short positions next week.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.