Why you shouldn't use sentiment indicators when trading

Many traders and investors use sentiment indicators when making trading/investment decisions. I don’t use these indicators in my Medium-Long Term Model or Day Trading Model. Here’s why.

“Complacency” is a concept that’s extremely hard to measure

Sentiment is supposed to be used as a contrarian indicator (in the case of “dumb money” or a trend following indicator (in the case of “smart money”).
As a contrarian indicator, sentiment is supposed to measure “complacency” and “excessive fear”. Here’s conventional thinking with regards to using sentiment data.

  1. When the “dumb money” is super bullish, the market should be near a top because investors/traders are all in and no one is left to buy.
  2. When the “dumb money” is super bearish, the market should be near a bottom because investors/traders are all sitting on the sidelines and no one is left to sell.

It’s extremely hard to measure “complacency”. That’s why so many different sentiment indicators give so many different results! It’s not possible to ask each and every single investor/trader “are you bullish or bearish today?” And even if you could poll every single person every single day, you still need to ask them “are you bullish/bearish for the short term, medium term, or long term”? Such an accurate sentiment indicator would be impossible to create.
In addition, the way sentiment surveys are conducted change from time to time. So the “same” sentiment number might be different over time! E.g. 80% bullish today might = 75% bullish 20 years ago due to the way the sentiment indicator is calculated.

There is no such thing as forever “smart money” or “dumb money”

Historically, there is no such thing as “smart money” or “dumb money”.

  1. The “smart money” is typically contrarian while the “dumb money” is typically trend following.
  2. When the “dumb money” is big enough, they overpower the “smart money” and make the smart money look like fools.
  3. Complacency isn’t always a bad thing. Neither is excessive fear.

Smart money likes to buy into declines and sell into rallies. In other words, smart money likes to pick tops and bottoms. Meanwhile, dumb money likes to chase declines and rallies.
But the smart money isn’t always right! When a trend is insanely strong (i.e. the middle part of a bull or bear market), the smart money will be very wrong while the dumb money will be very right.

  1. In the middle of a bull market, the market will rally nonstop while the smart money is short. The smart money will eventually be forced to cover their shorts at massive losses while the market is rising.
  2. In the middle of a bear market, the market will fall nonstop while the smart money is long. The smart money will eventually be forced to cover their longs at massive losses while the market is falling.

Here’s a simple example. “Smart Money” commercial hedgers were consistently bullish on the U.S. Dollar in 2002 and 2003. The U.S. Dollar still went down.

In the financial markets, it’s just a question of whom is more powerful than whom. The dumb money can be so powerful and large in bubbles that it overpowers smart money. Let’s use Bitcoin as an example.
Bitcoin is clearly in a massive bubble.

The smart money has been calling Bitcoin’s top from $1k all the way up to $20k. Eventually the smart money will be right and Bitcoin’s bubble will burst. But in the meantime, the smart money will be made to look like fools. Markets can remain irrational longer than you can remain solvent.
In addition, complacency in bull markets isn’t always a bad thing. There will always be minor concerns/worries. But as long as the long term fundamentals and the majority of factors are bullish, then investors/traders are right to be complacent.

Sentiment becomes a weird indicator

A lot of investors and traders watch sentiment indicators. In essence, they’re all trying to predict the market by guessing what everyone else is trying to do!
So here’s my question: if everyone is worried about “extremely complacent/frothy” sentiment, then why is sentiment extremely complacent/frothy in the first place? Sentiment should be extremely bearish!
More importantly, you don’t need sentiment indicators to tell you when sentiment is extremely optimistic/pessimistic. The price will tell you that itself! If the market is crashing, then sentiment is extremely pessimistic. If the price is soaring nonstop, then sentiment is extremely optimistic. It’s as simple as that.

3 comments add yours

  1. Hi Troy, thank you for the post. I had a question.
    Does a correction usually need news, or an event to happen? or is it just possible that we wake and the market is down? What exactly drives the market?

    • Most of the historical small corrections were purely technical in nature. No fundamental reason/news.

  2. It is very great post Troy , I have been wondering since then if you use sentiment in your Model .

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