Market sentiment is the basis of all technical analysis. It is market sentiment that causes prices to diverge from what fundamental analysis would dictate to be the intrinsic, or true, value of an asset. It forms the patterns of charts and quantifies the indicators. Without market sentiment, there would be no bubbles or financial crises, since the price of everything would be determined by fundamental factors, not by what the market is doing.
Market sentiment is the emotions and the feelings of the market participants about the market and the economy. Investor psychology and behavioral finance are the study of how emotions move the market. The Efficient Market Hypothesis (EMH) postulates that prices are determined by fundamental factors, but reality shows otherwise. How else to explain the stock market bubble of the 1990's or the real estate bubble that followed a few years afterward? Although fundamental factors do ultimately rein in excess confidence or pessimism, greed and fear of the uninformed investors have a large effect on prices most of the time.
To illustrate, consider the stock market bubble. As stocks rise, stockholders become overjoyed as their wealth increases, which causes them to buy even more. They tell their friends, show them their portfolios, and talk about what they're going to do with their newly found wealth. As their friends hear this, and see in the news that the stock market continues its upward trend, then they, too, want to invest, for if they don't, they will have missed a great opportunity. When they invest, they bid stock prices ever higher, and as it rises higher, even more people pile in. Both the greed for more money and the fear of missing a great opportunity drives prices far higher than can be justified by the fundamentals of the underlying businesses. At the peak of the market, optimism is at a maximum.
But the market peaks because the overconfident people have no more money to invest, no more money to keep the stock market going up. As Joseph Kennedy noted at the end of the 1920's, when the shoeshine boy starts giving stock tips, it's time to get out. Why? Because even the shoeshine boy has already invested. There is no other pool of investors to keep the market propped up. When the market stops going up, then people become fearful that they will lose their wealth, so they start taking out their money. As stocks are sold and money is withdrawn, the stock market starts declining rapidly; people become ever more fearful and withdraw even more. Pessimism takes hold of the market, for who can know where the bottom is. And as more people withdraw their money, the bottom falls even faster and lower, until at some point, most of the money of uninformed investors has been withdrawn. Informed investors realize that the market has been oversold, and thus, start buying, preventing the market from falling further.
Market sentiment is often explained as a measure of crowd behavior, which is how people behave under the influence of other people. People have a strong tendency to conform to the crowd, and, thus, will think and act differently in crowds than they would have as individuals uninfluenced by others. Hence, people develop common ideas and common goals and start doing the same things. So when the crowd is buying, most others join in; likewise when they are selling.
It is this market psychology that forms the basis of contrarian investing—selling when the masses are buying and buying when they are selling. Contrarian investing could not exist if the efficient market hypothesis were true, since prices would only be determined by fundamentals. Contrarian investing can only exist because prices, more often than not, are determined by market sentiment.
Because it is determined by the expectations of the crowd, market sentiment is best used as an indicator for the general markets, not for specific securities. And because crowd expectations are varied and virtually impossible to quantify, market sentiment falls into 2 basic categories: bullish sentiment and bearish sentiment. So sentiment indicators are most often used with other indicators and signals to determine when to buy and sell.
Informed and Uninformed Market Players
To explain these market dynamics, the market is conjectured to be primarily composed of 2 groups: informed players and the much larger group of uninformed players. The informed player is considered the professional, who understands the valuation of assets according to fundamentals, but the uninformed players have little or no understanding of asset valuation, and, thus, is not a factor in their buying and selling decisions.
There are also liquidity players, who are market participants that buy or sell, not because of market forecasts, but because of organizational objectives or because they need the money, as when a pension fund needs to make payments to retirees or a mutual fund needs to sell to pay for redemptions, However, liquidity players are not thought to have a significant effect on prices most of the time, because their actions, motivated by individual needs, are not concerted.
Since the uninformed masses are a much larger group, they also have more money, and, thus, are a more important determinant of market prices. However, it would be wrong to assume that only uninformed players buy when prices are high and sell when they are low. For instance, in 1995, after the stock market had already risen considerably since 1990, it was still destined to continue rising over the next 5 years. If informed players didn't buy during this period, then they would have missed many profitable opportunities. Indeed, if they had sold short, thinking that assets were overpriced compared to fundamentals, they would have suffered substantial losses. Hence, because market sentiment seems to be more important in the pricing of securities than fundamentals, a trader who accurately forecasts market sentiment will be more successful than one who only considers fundamentals. In this way, even informed players are swayed by the crowds.