Be wary of the ‘vibes’: positive investor sentiment doesn’t necessarily match the true value of stocks

Global stock prices dropped across the board late last year, by between 10% and 15% in a matter of weeks^[1].

Fears of a recession took hold after a series of interest rate increases, stubborn inflation and geopolitical tensions in Europe and the Middle East. Uncertainty gripped the market and eroded investor sentiment, only for markets to bounce back^[2] and finish the year on a high.

Stockmarket history is full of similar periods characterised by either extreme levels or dramatic changes in stock prices. This creates patterns that are difficult to reconcile with asset-pricing models. These models are based on the assumption that prices always reflect reasonable expectations about future cash flows determined by rational investors.

But investors are not always rational. Rather, a large body^[3] of academic literature^[4] shows market-wide sentiment can cause prices to depart from their true values.

In an ongoing collaboration between the University of Canterbury and the New Zealand Shareholder Association (NZSA), we have developed the NZ Retail Investor Sentiment Index^[5] as a representative survey of retail investors in New Zealand.

The goal is to understand the behaviour of New Zealand’s investors and how they compare with their overseas colleagues when predicting the patterns of the stockmarket.

Measuring market sentiment

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.

Several studies show investor sentiment predicts stock returns and can be used as a contrarian signal^[7] since subsequent returns tend to be relatively high when sentiment is low and vice versa. Therefore, a contrarian investor would buy stocks when sentiment is low and sell stocks when sentiment is high.

Read more: Mood, music and money: what our Spotify playlists reveal about the emotional nature of financial markets^[8]

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.

Our index is constructed similarly to those in the United States^[9] and Europe, which are often cited in the media^[10] and widely used in research^[11]. All these benchmarks provide insights into the mood of investors and shed light on the short-term outlook for the local equity market.

2024 forecast for the NZ 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.

Why investor sentiment matters

In general, investor sentiment affects the demand (buying) and supply (selling) of stocks. At the aggregate level, this can affect stock prices and volatility.

Understanding the level and changes in the overall attitude or mood of investors therefore has important implications for investors to make better investment decisions.

At the same time, policymakers should monitor and include investor sentiment in their decision-making to reduce undue market volatility. Research has shown^[12] sentiment as a determinant of stock prices is driven by rational factors, such as inflation, overall market return and dividend yield, and less rational factors.

Read more: It's the 'vibe' of the thing: the critical art of measuring business and consumer confidence^[13]

Regulators typically focus on the former, which by extension contributes to maintaining stability in sentiment and associated price volatility induced by fundamentals.

But changes in sentiment unrelated to fundamentals^[14] are just as important. They can occur without warning and spread widely through the market. This has been found to play an important role for price run-ups and corresponding corrections that can have negative impacts on the functioning of the financial market^[15] and asset price bubbles and monetary policy^[16].

Considering the importance of investor behaviour for the wider economy, the patterns identified by our index give us a road map to better understand the ups and downs of the New Zealand stock exchange.

References

1. ^{^} 10% and 15% in a matter of weeks (www.nasdaq.com)
2. ^{^} bounce back (fortune.com)
3. ^{^} large body (onlinelibrary.wiley.com)
4. ^{^} academic literature (www.journals.uchicago.edu)
5. ^{^} NZ Retail Investor Sentiment Index (www.nzshareholders.co.nz)
6. ^{^} Hagen Hopkins/Getty Images (www.gettyimages.com.au)
7. ^{^} can be used as a contrarian signal (www.aeaweb.org)
8. ^{^} Mood, music and money: what our Spotify playlists reveal about the emotional nature of financial markets (theconversation.com)
9. ^{^} United States (www.aaii.com)
10. ^{^} media (www.nasdaq.com)
11. ^{^} research (doi.org)
12. ^{^} Research has shown (doi.org)
13. ^{^} It's the 'vibe' of the thing: the critical art of measuring business and consumer confidence (theconversation.com)
14. ^{^} changes in sentiment unrelated to fundamentals (doi.org)
15. ^{^} functioning of the financial market (www.sec.gov)
16. ^{^} asset price bubbles and monetary policy (www.federalreserve.gov)