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Kulshan Equity Market Sentiment Index
Market
sentiment is a term often mentioned in both academia and in the
financial media. In his seminal work of 1936, The General Theory
of Employment Interest and Money, John Maynard Keynes used the term
“animal spirits” to express the idea that aggregate economic activity
may be driven in part by waves of extreme optimism or pessimism.
During the 1998 Long Term Capital Management Crisis , we came to
realize that sentiment was one of the primary drivers of the
crisis. We also discovered that the standard approaches of
measuring of market sentiment were inadequate in terms of estimating
how investor sentiment can affect the markets.
To better
understand and quantify market sentiment, we employed a very different
methodology from the other two major methods used to estimate sentiment
in the US equity market. Rather than using a survey-based
approach such as the AAII Investor Sentiment Survey or an econometric
approach like Citigroup’s Panic/Euphoria Model, we turned to textual
analysis to gauge investor sentiment. Specifically, we developed
a method to measure sentiment based on the words being used to describe
subjective expressions about the US equity market.
As traders,
we attacked the problem from a different perspective than a linguist or
an economist might. We were interested in understanding the
aggregate emotional make-up of traders and whether this could be
expressed quantitatively. More importantly, we wanted to
determine whether such an indicator was merely coincidental or had
predictive properties. In short, by analyzing the emotional
content of text discussing the market, we believed that we could
accurately gauge the current aggregate sentiment statement of investors
and then implement trades to take advantage of that sentiment state.
We were not to be disappointed.
Since
the start of our daily measurement process on November 2, 2000, we have
amassed over 150,000 US equity market sentiment data points. We have
found significant statistical evidence that the Kulshan Market
Sentiment Index is predictive of short-term market behavior and
provides us an edge in trading the overall stock market as defined by
the S&P 500 Index.
The core assumption of
our model is that sentiment follows a cyclical path. Market sentiment
does not swing from optimism to pessimism and back again in a linear or
digital fashion, but rather through an evolution over eight core
sentiment states: Contentment, Hope, Fear, Despair, Apathy, Caution and
Joy, as depicted by the graphic below.
As
our research has shown, particular evolutions of sentiment repeat
themselves time after time providing a number of high probability
trading set-ups in the S&P 500 Index derivatives market.
These sentiment set-ups provide the core trading strategy for Kulshan
Capital Management, LLC.
Below we describe the basic characteristics and investor thought patterns for each of these eight sentiment states:
Contentment:
A moderating euphoric sentiment state, where equity prices have likely
already retreated from recent highs, yet investors remain rather
sanguine about further market upside. Investors continue to feel
confident that the market is “bullet-proof”, remain optimistic about
current stock picks and are unconcerned about potential downside.
Hope:
A fading euphoric sentiment state, where new highs are no longer being
made. However, underlying fundamentals remain in tact, yet
potential problems begin to surface. As a result, denial of potential
downside runs high by investors. The bulls use dips as an
opportunity to buy more stock.
Fear:
A growing bearish sentiment state, where recent lows have begun to be
violated and new information is confusing. Emotion seems to be
driving lower prices and not reason. Thus, investors are afraid to sell
owing to the fear of appearing foolish.
Despair:
An extremely bearish sentiment state, where prices continue to
fall. Investors feel that they missed their opportunity to
sell and then often capitulate deciding to sell owing to fears of
further losses. Equity prices are generally beginning to approach their
near-term lows.
Apathy:
A declining bearish sentiment state, where prices are trading around
their near-term bottom. In this phase of the sentiment cycle, many
investors have “given up” on the market and stop trading. Many
feel that the “market is evil” or that the “the game is rigged”.
Watching the market becomes difficult, as volatility tends to be at
peak levels. Getting long the market in this state is usually viewed as
“too risky”.
Caution:
A moderately bearish sentiment state, where prices have begun to
recover but underlying fundamentals remain unchanged and suspect.
As a result, skepticism abounds and every sharp rally is classified as
a “bear market rally”. New positive information tends to be
discounted and dismissed. The bulls are still unwilling to “buy
the dip”.
Greed:
A growing bullish sentiment state, where prices start to take out prior
resistance levels with ease. Regret tends to be widespread, as
investors begin to show remorse over how cheaply they could have bought
stocks just a few days or weeks prior. Investors feel the need to
“get back in the game” and hence equity prices continue to move higher.
Joy:
An extremely euphoric sentiment state, in which equity prices have been
rallying and making new near-term highs. This is the ideal state
for the bulls. Positive price reinforcement leads to an endorphin high,
which leads investors into positioning themselves with “all-in”
mentality.
Over time sentiment generally moves
through this cycle in a clock-wise fashion, though it tends to
alternate between two to three of the eight states on a daily basis.
Based on our analysis of this sentiment data, the evolution of
sentiment is by no means random process and one tends to see specific
short-term evolutions of sentiment, which correspond to likely future
short-term market price movements, repeat time and time again.
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