Investor sentiment and stock prices

Last week in my ECONS101 class, we covered (among other things) the economics of financial markets. In particular, we looked at explanations for why the value of financial assets rarely represents the expected value of future cash flows or profits (the asset's fundamental value). As part of this, we discussed the formation (and the bursting) of asset bubbles.

Asset bubbles form because of self-fulfilling prophecies: If investors believe that the price of a financial asset is going to go up, many will buy the asset. This raises the demand for the asset, and the price of the asset goes up, which is exactly what investors expected to happen. Because the price is increasing and this increase is due only to investors’ expectations about the future, the price of assets gets pushed beyond the asset’s fundamental value – this is an asset bubble.

Notice the key role of expectations in the formation of asset bubbles. Investors' expectations can be affected by any number of different things, one of which is their general mood (as shown in this research). In other words, investor sentiment is an important component of investors' expectations, and is therefore an important factor in asset prices. As John Maynard Keynes wrote in The General Theory of Employment, Interest and Money:

...the market will be subject to waves of optimistic and pessimistic sentiment, which are un-reasoning and yet in a sense legitimate where no solid base exists for a reasonable calculation...

Knowing that I would be covering this topic, and the importance of sentiment I was interested to read this article in The Conversation by Jedrzej Bialkowski and Moritz Wagner (both University of Canterbury), back in May. They have developed an index of investor sentiment for New Zealand. As they explain:

Market sentiment refers to the overall attitude of investors. It is commonly summarised as bullish (expecting increasing prices), bearish (expecting decreasing prices), or neutral (expecting no or only little changes in price). Such sentiment is not always based on fundamentals such as revenue, profitability and growth opportunities...

Every week since January 2020, we asked registered members of the NZSA whether they expected the stockmarket to increase (bullish), decrease (bearish) or stay the same (neutral) over the next six months. The NZSA has about 1,200 members, a quarter of whom receive email invitations to participate in the survey.

Bialkowski and Wagner then use their index of sentiment to explore the New Zealand equity market:

During the first four weeks of this year, expectations that stock prices will rise over the next six months remained elevated at 40%. In other words, 40% of the surveyed investors believe the NZ equity market will increase in the first six months of 2024. At the same time, bearish sentiment, expectations that stock prices will fall over the next six months, fluctuated around 16%.

So, despite the mounting global and local uncertainties, retail investors are optimistic about the equity market. Bullish sentiment is stronger and bearish sentiment weaker than the historical average levels of 28% and 36%, respectively.

On the back of last year’s strong market performance and a better-than-expected economy, investor optimism carries forward.

However, since sentiment is known to be a contrarian indicator, informed investors should be cautious going further into the new year.

There is definitely some hedging of bets in that last sentence. It will be interesting to see how this measure of investor sentiment performs over time, and whether it has any predictive value.