Market Sentiment: Definition, Indicators & Formula

Instructor: Douglas Stockbridge

DJ Stockbridge is currently pursuing a Masters degree in Accounting.

In this lesson, you will learn the definition of market sentiment as well as several indicators that will give you a 'snapshot' of market sentiment. We'll conclude the lesson with some general advice regarding using market sentiment indicators.

Thanksgiving Day

Imagine it's Thanksgiving Day and you have been given the formidable task of cooking the turkey. Let's assume it has been roasting for a while. You want to check on whether or not it's done. What are the different ways you can check? Well, the most common way is to put a thermometer in the meat of the turkey. You can also cut into it and look and see if it's cooked, or you can assume it is cooked or not based on your prior knowledge of how long a turkey of that size needs to bake at that temperature. So we see that there are many ways to check whether the turkey is ready to be pulled out and eaten.

Well, in investing there are many ways to measure how 'hot' or 'cold' the stock market is. And generally, these words are used to describe the feelings investors have on the stock market at that time. Another name for this is market sentiment. The 'hotter' the market, the more optimistic people are about the future gains of the stock market.

In this lesson, we'll discuss different measurement tools to gauge whether investors think the stock market is cold, hot, overcooked, or undercooked.

Market Sentiment Indicators

There are many types of indicators. We'll cover a few of the most popular in this section:

Valuation metrics

These are also called the P/E or CAPE ratios. These metrics measure how expensive or cheap the stock market is by comparing the current market's price to its financials. The most common indicator is the P/E ratio. The formula for this is the market price / past 12 months' earnings per share. The higher the P/E ratio, the more expensive the market. The lower the P/E ratio the less expensive the market. Instead of earnings, analysts can use the book value of the equity, dividends, cash flow from operations, or free cash flow.

Technical indicators

This is also called the 100- or 200- day moving average. Technical analysis deals with making stock market predictions based on recent price movement in the stock market. Market participants look to such things as the 100- day moving average. If the stock market's price breaks through its 100-day moving average, it is considered a 'bullish' signal that the market will cotinine to increase.

Futures contracts

These (such as S&P 500 Futures) are contracts that allow the buyer to receive delivery of shares at a future date. The buyer pays for those shares now in hopes that the market price of those shares will increase by the time he or she receives them. Taken as an aggregate, the number of people willing to buy or sell these future contracts gives an indication of where investors think the stock market will be in the future. Big demand to buy the contracts indicates an optimistic average investor.

Social media

As social media has become a more popular form of communication people have looked to social media as a way of gauging market sentiment. For example, data mining firms look at what people are tweeting, searching, and posting about the market. They'll combine all this data to create a mosaic theory about where the general market is headed.

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