Beware, but use investor sentiment to help with hard to value stocks

 

Investor sentiment, defined broadly, is a belief about future cash flows and investment risks that is not justified by the facts at hand. Sentiment has a market impact on longer-term fundamentally based investors because betting against sentimental investors can be costly and risky. Smart traders and arbitragers may not be able to offset the flows from sentiment in the short run. You can call sentiment traders, noise traders that introduce volatility associated with different use of information. Hence, sentiment can cause deviations from fair value. Some stocks will be more sensitive to sentiment than others, so sentiment can be incorporated in investment decisions. See "Investor Sentiment in the Stock Market". 

Sentiment measures can either be top-down or bottom-up. Given our macro focus, we will discuss some top-down conclusions. Top-down sentiment focuses on aggregated reduced form measures.  Bottom-up sentiment uses or tries to measure investor biases. Some categories of stock are more sensitive to sentiment: low capitalization, younger, unprofitable, high-volatility, non-dividend paying stocks, growth stocks and firms in financial distress. Stocks that are harder to value or more difficult to arbitrage will be subject to more sentiment risk because investors will try and use other measure to form expectations and create a perceived edge. Sentiment is associated with the propensity of marginal investors to speculate on non-fundamental information.

High (low) sentiment will push speculative stocks above (below) fair value. Easy to arbitrage or value will have less variation from fair value based on sentiment. These speculative harder to arbitrage stocks will have higher (positive) sentiment beta while more bond-like stocks will have negative sentiment betas. As information is revealed, prices should move back to fundamentals. 

What can be used for macro sentiment:

• Investor surveys - Consumer confidence correlates with small caps and stocks with strong retail interest.
• Investor mood - Some researchers have found a mood associated with weather and daylight.
• Retail investor trades - Retail investors herd and can push speculative stocks.
• Mutual fund flows - Flows are often tied to retail sentiment and will drive speculative stocks.
• Trading value - Volume changes represent differences in opinion and especially impact stocks when short selling is difficult.
• Dividend premium - Given more "safe" bond-like returns, there will be a premium difference.
• Closed-end discount - The deviation from net asset value can proxy for retail sentiment.
• Option implied volatility - Option flow trading will impact volatility and describe speculative and hedge trading.
• IPO first-day returns - Serves as a measure of speculative fever.
• IPO volume - Bring new firms to market is based on perceived market optimism.
• Equity issues over total new issues - A broad measure of equity financing activity. 
• Insider trading - A measure of what corporate insiders think about their company.

These sentiment measures can be used in concert to form a sentiment indices which can measure the deviations from fair value of speculative stocks. Sentiment can proxy for speculative demand that may be reversed as new fundamental information is released. Positive sentiment can push prices higher and create volatility only to be reversed as news enters the market.

Sentiment may not be based on fundamentals, but it can play an important role for exploiting opportunities in hard to value (arbitrage) stocks. Sentiment in other asset classes that are hard to value can be employed to measure market extremes.