Investors employ various methods of analysing not only companies of interest but also the broader market. Among them are the more popular approaches such as fundamental analysis and technical analysis.
What sets apart investors who harness sentiment analysis is their keen sense of prevailing feelings surrounding the market or a stock. However, they do not base their decisions solely on their own opinions, but instead, they consider, take a cue from, and give weight to the widespread beliefs of other investors.
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What Can You Gain from Sentiment Analysis?
The sentiment of the market or a stock adds a set of information that fundamental and technical analyses do not cover completely. With comprehensive information, investors are well-informed and better-enabled to make smarter decisions.
Sentiment analysis is classified into two primary methods. The first method seeks to predict market trends and reversals. The second—enabled by recent data innovations—allows investors to more accurately predict individual stock returns. Using large datasets for returns predictability is achievable with sentiment analysis.
Sentiment analysis can also be explained by a branch of financial economics, specifically the branch known as investor attention of behavioural finance. When employed and executed systematically, sentiment analysis can potentially yield greater rewards.
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What’s the Purpose of Market Sentiment?
Understanding the sentiment of the broader stock market helps investors make crucial decisions. Foremost of these decisions is whether to enter the equity market or allocate funds to other assets.
The process requires getting a sense of whether most investors are feeling bullish (greed) or bearish (fear). And several indicators can help estimate the greed or fear levels in the market.
Surveys are among the widely used ways to gauge bullish or bearish views. These are usually carried out through phone interviews to determine investors’ thoughts on the market. The raw results are aggregated to ascertain positive, neutral, or negative attitudes. The University of Michigan Consumer Sentiment Index (US) and BlackRock Investor Pulse Survey (International including Singapore) are examples.
The second most important investing decision hinges on assessing whether the market is trending, reaching the top or bottom (potentially a reversal), or showing levels of either large or little volatility. Armed with this information, investors can calibrate their strategy and ride the waves like a pro.
The Volatility Index (VIX), published by the Chicago Board Options Exchange (CBOE), is a popular indicator of such behaviour. The index is a computation of the expected annualised change in the S&P 500 index over the next 30 days, using options-based theory and current market data.
The VIX was used extensively to judge investor sentiment during the Global Financial Crisis of 2007 and the Euro Crisis of 2009. However, these market sentiment indicators are not a definitive gauge of where overall market sentiment leans and should be used on their own to trade.
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How can you get Firm Sentiment using data?
Investors can now measure what others are thinking as regards a specific company, thanks to rapid advances in computing power and text analytics algorithms. Textual sentiment on firms is becoming even more popular and accessible, although it requires more advanced knowledge in handling data.
The methods of extracting firm sentiment from textual data are similar. Investors generally employ text analytics to download, clean, and classify words in an article to determine if the mood about a company is positive or negative. The nuances are in the data sources they use.
The primary source of data is the popular financial news platforms. It’s a fact that many investors read articles on the Wall Street Journal, Financial Times, and other mainstream news sites. As such, these articles can influence the swarms of investors. Research shows that the impact of the news on stock performance differs across authors, of varying popularity or renown, in the same site[1].
Another popular data source is the microblogging platform Twitter—given the sheer speed at which tweets spread over the internet. Add to this the immense volume of tweets from commentators. Regardless of the 140-character limit per tweet, Twitter helps predict stock prices and volatility, especially tweets surrounding corporate announcements, like earnings reports[2].
Another way to understand firm sentiment is to look at internet search behaviours. The most prominent tool used to this end is Google Trends, which tracks search volume and assesses if a company is getting more attention than usual.
However, there’s a downside: it’s not always apparent if a company is getting noticed for positive or negative reasons. Therefore, internet search behaviours are less useful than the two previous data-sourcing methods. Notwithstanding, the data can still be used by investors to forecast the possibility of volatility—whether incoming or imminent volatility.
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The Takeaway
Sentiment Analysis can be a valuable asset and a must-have in the investor’s toolkit. Granted, it requires extra effort to execute, especially when it comes to firm sentiment. The method should correctly and consistently be implemented.
Rather than using available individual evaluation methods exclusively, sentiment analysis should be integrated into other forms of analysis. That way, you have at your disposal a comprehensive mix of systems that are not only systematic but also effective in producing better results.
By Dr. Jinghao Ke, Research Room Pte. Ltd.
RESOURCES:
[1] Dougal, C., Engelberg, J., Garcia, D., & Parsons, C. A. (2012). Journalists and the stock market. The Review of Financial Studies, 25(3), 639-679.
[2] Al Nasseri, A., Tucker, A., & de Cesare, S. (2014, October). Big data analysis of stocktwits to predict sentiments in the stock market. In International Conference on Discovery Science (pp. 13-24). Springer, Cham.