This article was originally published in the Against All Odds Research November 2021 Issue
There's an old Wall Street legend that JFK's father sold out ahead of the 1929 crash after overhearing a shoeshine boy giving stock tips. If you follow financial media, you can probably recall numerous such 'indicators' which marked the tops of various bull markets. It's obvious the day trading bubble in Nasdaq stocks was bound to end when nurses and hairdressers quit their jobs to day trade all the IPOs they knew nothing about. The sub-prime bubble was also obvious (d-uh, liar loans), in hindsight. And now, it's obvious markets have peaked because of the craze around NFTs.
As a market historian, such events are fascinating as they capture the zeitgeist of that period. As a trader, evaluating sentiment based on such anecdotal evidence is a double edged sword. Humans are biased. We tend to read market sentiment through our own lens, which is in itself a reflection of our sentiment towards what we perceive to be happening.
Be in this game long enough, it is impossible to not be wrong every so often. Sure, it's fun to take a dig at the Twitter celebrities who got it wrong. The unseen is all the people who followed them blindly and stayed out of the markets, selling the dips and waiting for the crash that never came. These people paid a high price primarily because they mis-read sentiment, which led to poor decision making.
And that's really my point: unless you're a quantitative trader, it's impossible to not let sentiment affect your trading decisions. You need to have a plan to deal with it, knowing that your read on sentiment will be right and wrong at various points in your career. Most importantly, if you have a strong view on something, you have to ensure that view doesn't interfere with making money.
The true believers don't trade - they take positions and then take to Twitter to explain why they are right. They never alter that view, since doing so would not appeal to their audience.
When someone who doesn't share the same view looks at these tweets, the sentiment analysis can go one of two ways: (1) the existence of such cliques and their growing strength is a sign a new bull market is beginning, or (2) a sign that a particular market is in a bubble that's about to burst.
The role of extreme opinions as a sentiment indicator is only obvious in hindsight, based on the price action. If ethereum and NFTs crash in the next couple of weeks, Raoul's tweet on NFTs will go down in infamy. If the bull market takes crypto to $6 trillion market cap and NFTs lead the way, Raoul will be revered as a prophet. Either way, it is the subsequent price action which will be used to judge market sentiment. And that's the takeaway here - if you can focus on the price action, you can ignore the opinions on Twitterverse. There's no need to care about whether this is the top or the bottom of the market. That has absolutely nothing to do with making money trading.
Realizing this was a breakthrough for me. I came into finance from the tech sector, and my first forays into "investing" were based on the recommendations of the market gurus. These smart guys could read market sentiment from tea leaves proprietary models and use it to be 'contrarian'. When the price action is bullish, they would interpret it as bearish, and vice-versa. They would make money buying puts ahead of every dip in the Nasdaq and advertise the fact (what they wouldn't tell you is that by being short all the time, they actually lost money on their put buying strategy). The sentiment readers attract a crowd, who then rely on their predictions to make portfolio decisions.
Like the wedding goer in the Rime of the Ancient Mariner, I was hooked to the seeming prowess of these sentiment readers. There was even a time when I thought I needed to predict right in order to make money.
The aha moment was when it hit me that any analysis of sentiment depended entirely on subsequent price action. Right or wrong is only determinable in hindsight. So, if sentiment is merely a derivative, it can be ignored in favour of understanding price action. As a fundamentals based trader, I believe fundamentals drive price action (I may not understand what the fundamentals are, but that's beside the point here). If I focus on fundamentals and price action, I don't really need to deal with sentiment and the inherent bias that creeps in because of my interpretation of sentiment. Which also means I don't have to bother with the gurus or their predictions; I can dismiss all opinions as irrelevant to my decision making, and simply focus on the two factors that are important to me - fundamentals and price action.
I have been disconnected from my usual information sources (RealVision, Twitter, MarketWatch, Yahoo Finance) for over a month now. Rather than have a lot to catch up on as I got back to my desk this week, I realized I actually didn't miss much.
Could it be that sentiment analysis is overrated?
Something to keep in mind when reading strong, well-argued, compelling opinions which form the basis for a trade.