The Power of Sentiment

Sometimes my daughter loves snorkeling. Sometimes my daughter hates snorkeling. The only difference seems to be whether her brothers have annoyed her before she gets in the water.

Last week we hosted a seminar at our office and during the discussion, I tried to emphasize the idea that market moving events don’t occur in isolation and, in the short-term, sentiment controls everything. (Click here for copy of the slides.)

Investor sentiment is the general outlook investors have for the financial markets.  Typically, when things are going up, investors are happy, and the market sentiment is positive.  But when the markets are going down, investors feel discouraged, and the sentiment is negative. 

The important thing to remember is that the same events can trigger very different results depending on whether prevailing market sentiment is positive or negative.

In his book, Mastering the Market Cycle, Howard Marks describes some of the mental gymnastics investors go through to justify market rallies when sentiment is positive.

Strong data: economy strengthening—stocks rally / Weak data: Fed likely to ease—stocks rally. / Data as expected: low volatility—stocks rally

Banks make $4 billion: business conditions favorable—stocks rally / Banks lose $4 billion: bad news out of the way—stocks rally

Oil spikes: growing global economy contributing to demand—stocks rally / Oil drops: more purchasing power for the consumer—stocks rally

Dollar plunges: great for exporters—stocks rally / Dollar strengthens: great for companies that buy from abroad—stocks rally

Inflation spikes: will cause assets to appreciate—stocks rally / Inflation drops: improves quality of earnings—stocks rally

Of course, when sentiment is negative, investors will look at the same headlines and see nothing but reasons to sell. 

Right now, the general market sentiment is favorable, and most news events receive a positive spin.  Need an example? One weekend we had an assassination attempt on the Republican presidential candidate. The market moved higher on the belief this made Republicans more likely to get elected.  The next weekend the sitting President and Democratic candidate dropped out of the race, potentially reducing the Republican advantage. Rather than reversing course, the markets again moved higher because “the dollar eased relative to foreign currencies.”  Heads or tails, the market wins.

At least based on today’s sentiment.  Eventually it will change.   

This is why predicting the short-term trading impacts of macroeconomic events is so difficult. “I think the Fed is going to lower rates by 25 basis points at their next meeting” may be a terrific prediction.  Unfortunately, it tells us nothing about how the market will respond when it happens. “Markets move higher as Fed rate cuts provide boost to consumers” and “Markets move lower as Fed forced to cut rates in response to weakening economic conditions” are both possibilities. 

Same event, same economy, but two very different results.  The primary difference is sentiment.