Blog : Investor Sentiment is Your Trading Advantage

by Peter Leeds on April 16th, 2009

"Investor sentiment" refers to how optimistic (or pessimistic) the majority of investors are feeling.  In other words, what beliefs and expectations do the majority of people have at the current time.  

This article will introduce you to this basic concept, which despite being simple to understand, is too often overlooked by the majority of investors.  If you want to review a more involved scenario where investor sentiment plays out, please review my blog entitled "Too Late for Panic."

If everyone thinks the stock market is about to crash, that represents highly negative investor sentiment.  If the world seems to be stampeding to throw their money into stocks, and even your great-grandmother is phoning you with her latest stock pick (similar to the environment when the Dot-Com bubble was being inflated), then that's highly optimistic sentiment. 

Now, here's the important part: Investor sentiment is a contrarian indicator. 

The greater the percentage of people that are optimistic, and the more optimistic those people are, the more likely the market will drop or crash.  If everybody expects shares in ABC Inc. to go up, they are highly likely to go down.  If 90% of investors believe that XYZ Corp. shares are going to collapse, then those same shares are probably going to go higher.

This truth occurs in the stock market for 2 reasons:

1. most investors are usually wrong
2. people act on their beliefs 

The second point, that people act on their beliefs, results in traders buying into stocks they expect to go higher, and that buying pressure pushes the shares higher and higher.  When everybody who thinks the stock will increase in price has bought, and that buying pressure disappears, the shares are usually overvalued and due for a fall.

The same holds true in reverse.  When the stock market crashes, and everybody is running for the exits, the mob mentality selling drives the prices lower.  Eventually the last panicking investor has sold.  

At that point, anyone you talk to will have a highly negative outlook about investments.  That's when negative sentiment has reached it's peak, and therefore traders are most likely to be wrong.  There aren't any more sellers, because everyone's sold, but they still believe there is even more downside.  Really all that's left are highly undervalued companies that won't go any lower, and are about to increase in price.

Use investor sentiment to your advantage.  It takes a lot of courage to buy when everyone else is selling, but the harder it becomes for you, the more likely that you are making the right move.