Don't be Sentimental
As we saw in Idiot Noise Traders it very much looks like there are people out there trading on the random oscillations in markets – which themselves make predicting the markets extremely difficult, particularly at times when irrational noise traders are dominating proceedings by synchronising their behavior. If this hypothesis is true then increasing ease of access to real-time internet trading data and opinions ought to be making markets less efficient, rather than more.
This implies that a contrarian investor should be looking to bet against the noise traders, rather than against the performance of stocks, so it's of significant interest to figure out what the current sentiment of day traders is. Some recent research on the behavior of investors using the microblogging site StockTwits offers some interesting clues to whether this might work.
Predictive Sentiment
'Sentiment' is one of those concepts that's quite difficult to pin down, but the general idea that it's whether investors are bullish or bearish on a stock. In the context of noise traders the idea is that they hold beliefs that aren't justified by the normal pricing metrics – stuff like cashflow or risks. There really isn't much doubt that investor sentiment can significantly affect markets – it's odd that there ever was – so the question becomes how to measure this, and how to exploit it.
Amongst the earliest research into the noise trader phenomena was Noise Trader Risk in Financial Markets, by De Long and colleagues, which posits that:"Much of the behavior of professional arbitrageurs can be seen as a response to noise trading rather than as trading on fundamentals. Many professional arbitrageurs spend their resources examining and predicting the pseudo-signals noise traders follow in order to bet against them more successfully. These pseudo-signals include volume and price patterns, sentiment indices, and the forecasts of Wall Street gurus."Of course, the rise of the internet has led to a whole new stream of information for and from noise traders and this has received plentiful attention from the research community. In Is All That Talk Just Noise? Werner Antweiler and Murray Z. Frank looked at the chat on internet stock bulletin boards and determined that sentiment didn't predict price movements. However, they did find that posting was correlated with both trading volume and volatility – which was a surprise, because it indicates that all…
