What Is Market Sentiment? Definition, Importance & Indicators

What Is Market Sentiment & Why Does It Matter?

Market sentiment refers to the dominant attitude of the market toward a particular security, industry, or financial market. It is the consensus feeling—positive or negative—about the near-future prospects of a stock, a commodity, an industry, or the market at large.

Obviously, financial markets comprise millions of players—ranging from individual retail investors to corporations to hedge funds—and not all of these players are going to have the same attitude. While one investor’s analysis might lead them to believe that stock XYZ is headed for the moon, a different investor might see weakness in that same stock’s financials and bet that it will crash and burn in the months to come.

Whether Stock XYZ goes up or down in value depends on its supply and demand—how many optimistic investors (bulls) want to buy it vs. how many pessimistic investors (bears) want to sell or short it—and a stock’s supply and demand depend largely on market sentiment.

In other words, investors act emotionally, and the herd mentality that dominates Wall Street can be just as important a determinant of a stock’s success as the underlying company’s actual fundamentals. The same can hold true for the market at large. Paying attention to market sentiment, both on a macro, market-wide scale and on a micro, individual-stock level, can help careful investors and traders capitalize on trends, fear, greed, and momentum.

How Is Total Market Sentiment Measured?

On a large scale, market sentiment can refer to how investors, both big and small, feel about an entire financial market (like the stock market) in general.

When investors are cautious and pessimistic, and prices are falling across the board, stocks are in a bear market. When investors are broadly optimistic, and prices are rising, stocks are in a bull market.

One easy way to gauge market sentiment about stocks in general is to examine the charts of bellwether stock indexes like the S&P 500 or the Wilshire 5000, as these indexes are considered benchmarks for the American stock market at large.

If the S&P 500 has been in a slow and steady decline for a few months, you can be reasonably sure that market sentiment is broadly pessimistic, or bearish. If it has been rising steadily in price, on the other hand, this is indicative of bull-market optimism among investors.

Watching stock indexes isn’t the only way to gauge sentiment, though—specific indicators exist to help investors analyze changes in market sentiment in the short term.

What Is the Daily Sentiment Index?

The Daily Sentiment Index, or DSI, is a popular leading indicator of short-term market sentiment. Its value, which can range from 0 to 100, is calculated using data about futures, currencies, and Treasury securities.

A score of 50 is the dividing line, with higher scores indicating bullish sentiment and lower scores meaning bears are in charge. Particularly high (85+) and low (≤15) scores are often taken to be signs of an impending reversal (i.e., a shift from bullish sentiment and rising prices to bearish sentiment and falling prices, or vice versa).

The DSI is particularly useful for active traders who buy and sell relatively frequently in an attempt to ride the momentum of the market and profit from short-term changes in sentiment toward individual stocks or groups of stocks.

What Other Sentiment Indicators Are There?

• CBOE Volatility Index (VIX): The volatility index, VIX, or “fear index” is another popular sentiment indicator. Higher readings indicate higher levels of fear, volatility, and instability in the market, while lower readings are indicative of relative complacency and stability.
• Fear and Greed Index: Also popular with sentiment traders, the Fear and Greed Index uses stock strength, options contracts, momentum, junk bond demand, and other data to produce a reading of between 0 and 100, with lower results indicating broad fear and higher results reflecting greed, which can be interpreted as overbuying, which many consider a signal to sell.
• Buffet Indicator: The Buffet Indicator, named for famed investor Warren Buffet, is usually calculated as the ratio of the market capitalization of the entire U.S. stock market to the current GDP. Historically, this figure has been highly correlated with total market stock index performance. In other words, when this ratio rises, stock prices usually rise as well, and vice versa.

How Can You Analyze Market Sentiment Toward a Particular Stock?

Regardless of how the market is doing at large, individual stocks often move independently of broader trends, so it is also important to be able to analyze market sentiment on a stock-by-stock basis.

Analyzing longer-term sentiment can be as easy as looking at a stock’s chart to see if it’s in an uptrend, a downtrend, or has been bouncing casually between support and resistance for a while, but for insights about a stock’s shorter-term market sentiment, the following indicators can be useful.

Short Interest

When someone shorts a stock, they borrow and immediately sell it, assuming it will go down in price before they have to repurchase it and return it to their lender.

A stock’s short interest is the proportion of its floating shares (those available for public trading) that are currently sold short. In other words, its the percentage of a stock’s available shares that are currently being used to bet against its success.

High short interest indicates poor market sentiment, while low short interest implies that few investors are confident enough about a stock’s future decline to bet against it.

Put/Call Ratio

Another way to examine sentiment toward a particular stock is to look at open options contracts. Put options allow their owners to sell a stock at a particular price by a particular expiration date, so they go up in value as the underlying stock goes down in price. Call options are the opposite—they guarantee their owners the right to buy a stock at a particular price before a particular expiration date, and they go up in value as the underlying stock increases in price.

In other words, put options are usually bearish, and call options are usually bullish. A stock’s put-to-call ratio compares a stock’s recent put option purchase volume to its recent call option purchase volume.

A result of 1 indicates that put and call volume are nearly equal, or that investors are relatively evenly split in terms of sentiment toward the stock in question. Lower readings mean fewer puts than calls, which is bullish, while higher readings mean fewer calls than puts, which is bearish.