Market sentiment, the collective attitude of investors toward the market, is one of the most powerful forces driving short-term price movements. Understanding and measuring sentiment provides valuable contrarian timing signals that can significantly improve investment results.
Measuring Market Sentiment
Several widely-followed sentiment indicators include the VIX (fear index), put/call ratios, the AAII Investor Sentiment Survey, and fund flow data. Each captures a different aspect of investor psychology, from options market positioning to individual investor attitudes.
The Contrarian Approach
When sentiment reaches extreme levels, markets often reverse. Extreme fear typically coincides with market bottoms, while extreme greed often precedes corrections. Warren Buffett's famous advice to "be fearful when others are greedy and greedy when others are fearful" captures this principle succinctly.
Sentiment Extremes as Timing Signals
The most reliable timing signals occur when multiple sentiment indicators reach extreme levels simultaneously. For example, a high VIX combined with elevated put/call ratios and bearish survey readings creates a powerful contrarian buy signal. Conversely, complacency across all measures warns of elevated risk.
Integrating Sentiment with Other Analysis
Sentiment works best as a confirmation tool rather than a standalone signal. When sentiment aligns with technical analysis and fundamental conditions, the resulting signals tend to be more reliable. Sentiment alone can remain at extremes for extended periods before the market reverses.