Can Stock Markets be Driven by Sentiment

“Can the market be driven by investor sentiment?” This is an oft debated subject in investing circles, particularly in light of the 2008 debacle in the stock markets.

Whether you are a market “bull or bear”, state of mind and outlook as to whether the glass is half empty or half full determines investor sentiment and therefore drives the entire market on any given day. Since the markets also follow a sort of “mob rule” mentality, the entire herd is often seen to move up, down or sideways. If investor sentiment is bullish we see an upward trend and consequently prices often rise. The inverse relationship holds true if sentiment has turned bearish and lower prices are the end result. On days when no one can make up their minds the market often gyrates up and down wildly during the course of the day with prices remaining essentially unchanged at the closing bell.

All of the above scenarios depend on investor sentiment and psyche more than any other factor associated with market forces themselves. Relative strength, Bollinger Bands, moving averages and the myriad of other technical indicators in play cannot overcome the sentiment and psyche of the investing community. Remember that it is the investor who spends the money, not the indicators of the market.

Investor sentiment is all too often driven by gut instinct when trading. Panic mode sets in and begins to grip the entire market, sending common sense and good judgment scattered to the four corners of the earth. One need only look to 2008 to see the complete disintegration of investor sentiment and confidence, not entirely without good reason. Considered by many to be the cornerstone of the modern day stock market, financial markets impressively collapsed. The failure of established brokerage houses and banks and the near bankruptcy of many other institutions shook the financial world as billions were lost overnight. “The sky is falling” mentality gripped a multitude of investors and as the crisis deepened, others seemed to awaken to the reality that “the emperor is wearing no clothes.” We are still reeling from the fallout and continue a slow, painful road to recovery that may take years. Indeed, we may never fully recover from last years debacle.

The opposite end of the spectrum is a feeling of drunken euphoria among investors that the good times will never end. How many years of easy credit lulled investors into a false sense of security and invincibility? Overconfidence and complacency replace diligent, critical thinking and are just as damaging for sentiment as the panic and fear aforementioned. Failure to plan and watch the markets in good times may lead to disastrous results later.

We can conclude that investor sentiment whether bullish or bearish does indeed drive the market one way or the other. Unfortunately, good judgment and critical thinking are often trampled underfoot as a result of this. The prudent investor always weighs all their options. It is what it is and will always be so as long as there is a market to be influenced.