Why investor sentiment matters

Picture this: A perennial Wall Street favorite is reporting earnings. The numbers are incredible—blowing past even the most ambitious forecasts from analysts. The CEO predicts record-breaking demand, and management raises its revenue forecast for the year ahead.

And then the stock drops 10%.

It’s the kind of counterintuitive reaction that makes some traders feel like the stock market is impossibly rigged. But in most cases, you can trace those wild, seemingly inexplicable moves to a common source: polar extremes in investor sentiment.

While that might not sound particularly reassuring, it shouldn’t discourage you, either. Here’s why: Over the years, some of Wall Street’s greatest minds have developed several useful metrics to track and measure these sentiment extremes. And by learning how to interpret those indicators, level-headed investors can cut through the noise and stay ahead of emotional, mob-driven reactions.

What does this look like in the real world? Consider the infamous tulip mania in 1600s Holland, when bulb prices exploded to record heights. Or there’s the more recent dot-com bubble of the late 1990s, when intense market optimism led former Federal Reserve Chairman Alan Greenspan to coin the phrase “irrational exuberance.” 

Both moments brilliantly capture how frenzied, optimistic speculation can take hold en masse and send asset prices spiraling upward, completely untethered from their true value. They also make for powerful case studies on the effects of unbridled greed.

Of course, history (and some simple math) tells us that buying and holding quality assets is the most effective way to build wealth in the stock market, given the power of compound interest. But the idea that there’s proverbial gold waiting to be struck on Wall Street is no doubt enticing. And when big profits start piling up in one corner of the market, serious FOMO can take hold. 

So now, picture an entire market fueled by peak greed, with investors chasing the same sure thing higher. The rocket ride up can be thrilling while it lasts, propelled by waves of new money pouring into the trade. But the fall back to earth? That’s often swift and painful, as buying power runs out and asset prices crumble at the first hint of bad news or technical weakness. 

Under these most extreme conditions, such greed-driven buying frenzies become cautionary tales. And when the fallout from new market peaks is particularly rapid, it leaves investors feeling frustrated, wary, and tempted to run away from the markets entirely. But more often than not, once the despair of the downtrend reaches its own bottom, these extremely bearish environments could present a compelling buying opportunity.

Why? Once the downtrend in a given market has become so severe and so relentless that hope for recovery seems lost—aka, the peak fear phase—selling pressure is finally exhausted. Then, even the faintest glimmer of good news could be enough to spark a rally.

Investor sentiment cycles can have a powerful impact on asset price performance. Yet understanding investor expectations is both an art and a science. That’s where sentiment analysis comes in—attempting to measure the level of optimism or pessimism among investors about a specific stock or sector.

It’s true that Wall Street is hardly a single, unified voice. Opinions on a given asset can range from bullish (optimistic) to bearish (pessimistic)—and all points in between. However, investor sentiment becomes especially significant when it reaches extreme euphoria or despair. That’s when it’s most valuable—and insightful—as an indicator for shifting asset prices.

As Berkshire Hathaway boss Warren Buffett famously wrote in an op-ed in The New York Times at the peak of the global financial crisis: “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.”

Imagine another scenario: Most people think tulips are a pretty good flower. Fair enough—they might even be right. But what happens if everyone suddenly agrees that tulips are the best flower ever? Next thing you know, a bidding war erupts for the last bouquet in the shop, driving prices to outrageous levels. That may be a peak in sentiment taking shape.

Think back to that hypothetical stock we mentioned earlier—the Wall Street favorite with strong earnings. Imagine that in the weeks leading up to the earnings report, half a dozen analysts raised their price targets on the stock—and a few even predicted a massive revenue spike. The company’s CEO made the rounds in major media, touting the success of their flagship products, and a popular movie star was spotted wearing the brand’s baseball cap. 

The result? Shares surged 20% in the 10 days prior to the quarterly release.

Knowing that investors had already priced in a meteoric rise, does Wall Street’s negative reaction to the stock’s actual earnings report seem slightly less surprising?

In fairness, that hypothetical is extreme. That’s why both quantitative and qualitative tools are useful in measuring investor sentiment. Together, they give the fullest picture of how bullish or bearish the overall mood is, plus how to track trends in those indicators.

Qualitative measures might encompass things like social media mentions and mass media coverage. Think of it this way: Any financial news story hitting the mainstream is most likely known—and quite possibly already considered in the stock’s price—by publication time. In 1979, for example, the cover of BusinessWeek magazine was emblazoned with the headline: The Death of Equities. On the 40th anniversary of that story, the publication (now owned by Bloomberg) marked the occasion by explaining why they’re “still getting grief” for the bold take, per economics editor Peter Coy. “Three years after that article appeared, the stock market hit bottom and then began a remarkable resurgence,” he wrote. “The total return on the Standard & Poor’s 500-stock index since its 1982 low, with dividends reinvested, has been nearly 7,000%. Not bad for a corpse.”

Today, decades after that premature obituary, mass media moves much faster. The rise of electronic stock exchanges, the growing popularity of options and exchange-traded funds among retail investors, and investing-focused social media have all created a flood of real-time data points for industry experts to pore over. 

That also means it’s easier than ever to accurately gauge how investors feel about a particular stock or sector—and ultimately, track how they act on those sentiments.

Quantitative measures of sentiment are crucial to understanding the bigger picture, because the metrics reveal more than what investors are saying on social media. This data reflects what investors are actually buying and selling day to day—the sentiment analysis version of watching what they do, not what they say.

Think short-selling data, option put/call ratios, ETF flows, and even hedge fund activity. These quantitative metrics are a helpful measure of not only what investors are buying and selling, but also in what size and how current activity compares to historical norms.

To help track this behavior when it comes to retail investors, Schwab developed its Schwab Trading Activity Index^TM, or STAX. Delivered monthly, it provides a quantitative view of aggregated trading behavior from a sample of Schwab’s millions of retail clients. By taking a democratized approach to analyzing customer portfolios, sectors, and individual stocks investors are buying (or selling), STAX can be a powerful tool for tracking investor sentiment—and making informed investing decisions. 

Also, keep in mind that sentiment analysis is just one piece of the puzzle, says Schwab Senior Trading Strategist Alex Coffey. Price and fundamentals are big pieces, too. It’s normal and expected to see heightened optimism toward a high-performing asset and relatively higher levels of negativity toward an underperformer. 

“But if the market is at all-time highs, put/call ratios are favoring a lot of call buying, and you’re also seeing volatility super-low—it’s almost like you have a really dried-out forest,” says Alex. “It doesn’t necessarily mean that there's going to be a fire, but if there’s any little spark, it could quickly reverse in the other direction.”

Using sentiment analysis to your advantage requires keeping a cool head when many around you may be losing theirs. Here’s how to stay focused:

Whether you’re trying to jump out ahead of the crowd or ride the momentum, do some soul searching to find your trade style and stick to it. “They can be loose guidelines, but understanding the type of trader you are can help you structure that plan,” says Alex.

There’s no need to go full Basel III. But Chris Jennings, Managing Director, Trading Services Products, at Schwab, says investors should understand and have a plan for worst-case scenarios, no matter how improbable. He suggests asking yourself: “If the S&P goes down 10% in a week, and I expect my portfolio to go down 20% in that scenario, am I okay with that? Or do I need to adjust? If it happens, what would I do?” 

This type of exercise could also help you dial in on hard numbers for hedging. Speaking of which…

“Hedge when you can, not when you have to,” says Alex.

“When the market's moving fast, particularly to the downside, it’s going to be really hard to make that level-headed decision,” he explains. “But if you have a plan ahead of time, you’re going to be able to act in a way that’s offensive instead of defensive.” 

Finally, remember that “the crowd” isn’t in charge of your risk exposure—you are.

“Your first line of defense in terms of risk management is order entry,” says Alex. “Deciding the percentage of your portfolio and the amount of dollars at risk—those are all things you can do before you even click the button.”

So the next time you see Wall Street react to earnings like a lead balloon, don’t panic. Instead, take a moment to explore the stock’s sentiment landscape. Who knows? You might just uncover a contrarian opportunity that even the Oracle of Omaha would approve of.