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How to Identify and Trade with Market Sentiment

In a recent episode of Tales from the Trenches, we highlighted 4 key differences between professional traders and retail traders.


One of these differences was that professional traders don't rely exclusively on charts. They use "outside information" like sentiment, seasonal or time-based influences, demand/supply dynamics, stop loss clusters and other pieces of information that represent an edge.


It's true that basic and robust technical analysis is valid (meaning mostly candle prints, key horizontal trendlines, momentum extremes and divergences) and levels the playing field between retail and institutional players. But to piece together a functional picture of the market you really need to factor in fundamentals, sentiment and positioning as well.


Today you will learn about Market Sentiment and how to include it in your trading.


What is Sentiment

Sentiment is defined as the overall feeling that market participants have about the future. Its sort of an emotional reaction that traders experience when they think about the markets, where the economy is headed, and how various trends in asset prices are evolving.


Your ability to read sentiment is heavily dependent upon knowing what is going on. You need to know what market participants are worried about. This is where the subject of news and data enters the picture.


Economic Data Releases

Data releases are your scheduled economic reports like GDP, PMIs, CPI, Employment, Retail Sales.


Know this: data in and of itself doesn't mean anything. To give you an example of what I'm talking about, lets use GDP. Why should a GDP print, which is backward looking, be market moving? After all, the purpose of financial markets is to discount the FUTURE value of asset prices. So a backward-looking piece of data shouldn't really move markets.


However, there is no way to predict what the future GDP will be, traders can only make decisions based on current data, and use that to make assumptions about where things are likely to go in the future.


This is probably the best starting point for thinking about sentiment.


There are many things that influence sentiment. But data is probably the easiest to start with because it's consistently available, and there are some fairly straight forward rules for how it influences participants' expectations about the future.


To understand how it will influence them, you first need to appreciate the concept of the business cycle.

Source: ACG Advisors


The business cycle is continuous, but for our purposes let’s assume that it begins, as this graphic shows, in the depths of recession. From there it moves to recovery... then upswing... and eventually the late upswing where it peaks...before returning to a new period of recession... hich terminates back at a trough. At that point the process starts all over again.


Asset prices have a high correlation with the business cycle. In other words, when the economy is in recovery, risk assets will begin rising as well. When the economy is hitting boom times, risk assets such as equities will likely also be experiencing a bit of froth. And the discussion of bubbles will be everywhere. As the economy passes the peak and turns toward recession, risk markets will soon follow.


However, it is usually only possible to identify the peak or trough of the Business Cycle after the fact. Going back to the GFC, until the day Lehman Brother collapsed, there was great confidence on the part of market participants that the economy was still in a boom period; and that the issues with subprime mortgages would be well contained.


Everyone knew that the boom would eventually end of course. But very few expected it to happen until at least several months into the future. Of course what we know now, is that the recession actually began around 6 months BEFORE Lehman collapsed. Only nobody had noticed.


The point is, market participants are constantly trying to assess an economy's stage in the business cycle, and there are literally trillions of dollars riding on trying to determine something that is basically unknowable until after the fact.


And ultimately, this is why things like the latest print of last quarter's GDP are so important. Nobody can know the future GDP, but they can look at the trend in GDP for the last 3 quarters, and try to combine that info with how GDP should be trending, given their assessment of an economy's current place in the business cycle. If the two line up, they can feel pretty good about their market positions. However, when they don’t, there’s a good chance they'll be a bit concerned about it.


ALL the data events that market participants pay attention to are evaluated in the same light.

The key point here is that, the data is important because market participants are trying to determine where an economy is in the business cycle. How closely the data matches up to where they assume the economy is in the cycle will influence their emotional reaction to the data. And the bigger the disparity between the two, the stronger the emotional reaction will be.


Headline Events

OK so now that we all have a pretty good grasp of how data and sentiment interact, let's build on that, adding Headline Events into the mix.


When we talk about sentiment, there are often several themes running at any one time. And it's not uncommon for some of these themes to be running counter to one another. The key differentiator is the time horizon.


Thus far we've talked about data and the business cycle, but that's really more of a long term sentiment driver. But for traders who are looking to only hold trades for a few hours - or even a few days - tracking the business cycle alone probably won't be enough to achieve their goals.


Of course, sometimes it is possible to trade scheduled news events and in particular the deviation from consensus, but nowadays it's rare that a scheduled event can really generate a good trading opportunity that is exploitable by us retail traders. You must know that the algos that are programmed to execute trades based on percentage deviations are in & out faster than you can blink.


But we don't want to fight windmills, and thankfully there is usually other stuff going on that people are concerned about, and more often than not these things are of a more immediate nature. Some examples of this would include the Coronavirus crisis, Fed tapering and normalization of interest rates debate, Biden's fiscal stimulus and the challenges to get it through congress...


These are all factors that market participants are currently keenly concerned with. But they all have a bit more of an immediate day to day relevance. All of these examples share something in common: they are all headline events.


While long term sentiment is driven by data and the business cycle, the short term is dominated by headline events. I've given you a few examples, but what are headline events in the abstract? What universally identifiable characteristics do they share?


As a general rule, they are political in nature. Economic outcomes are frequently at the mercy of important political actors, like the members of the FOMC board. The decisions of these actors can have such a profound impact on outcomes that financial market participants really have no choice but to worry deeply about what sort of decisions the political actors will make. And while its a fairly straightforward process to game out the most likely outcome given the known information a political actor has to work with, as all humans are prone to irrational decisions it's impossible to know with any real certainty what will actually happen until after the fact.


Not only does this create deep stress for market participants; it can often leads to wild swings in sentiment - and thus asset prices - when an expected outcome fails to materialize.

But more to the point, it will also tend to swing wildly every time new information enters the pool from which a political actor will draw when making his decision. Thus, a single political decision to be made weeks, or even months into the future can create trading opportunities day after day.


Once you realize that sentiment can be altered by headline events, and headline events are generally politically driven, you must also realize that the key to determining sentiment in the short and intermediate term, is figuring out:


a) what economically important political decisions are pending

b) what the possible outcomes are

c) what outcome is expected by market participants.


With that in hand, all that's left to do is either look for new information that will alter the markets perception of the most likely outcome, or wait for the decision itself to deviate from the one expected by market participants. Then you get in when the new information hits the market, and out after the information becomes embedded in price.


And that is about the best explanation for the process of not only reading, but exploiting sentiment that you are ever likely to hear.


Intermarket Analysis


Historically, one of the biggest problems traders have with sentiment is determining which headlines are important, which should be ignored, and how the important ones should be played. After all, the market's focus is continuously shifting: in 2007-2008 housing data was essential to track. Nowadays there's hardly any data print that the market cares about, outside of the pace of central bank bond purchases. PMIs have started coming back into focus but only recently.


To understand what the market cares about, we need to introduce Intermarket analysis: the process of analyzing the relationships between disparate financial market asset classes, in an effort to glean what market participants are thinking.


And how does it allow you to determine which headlines are important?

  • Every asset in the world has its own unique set of fundamental drivers;

  • Each headline has its own unique set of fundamental implications;

  • Depending on the nature of the headline it can cause asset correlations to take on some very interesting characteristics.

For example, if we have 2 simultaneous data prints coming out, A and B. Lets just assume that fundamental impact A will cause stock and bond prices to rise and that fundamental impact B will cause stocks to rise and bonds to fall.


Armed with this little model, after these two headlines hit, if we see equity and bonds rising we can infer that markets are more concerned with headline one then they are with headline two. In other words, headline one is the dominant driver of sentiment.


Of course this begs the question, why is headline 1 more important. Who knows? What's important is that we now know for sure that market participants are more concerned with headline A then they are with B. And this gives you an important clue about where to look when trying to figure out what's driving sentiment. It also gives you an important data point that you can evaluate the information you discover against.


Hopefully this is opening your eyes to how powerful a tool this is, but honestly this is really only the tip of the iceberg when it comes to the information you can gain from Intermarket analysis.


For example: imagine there is a big crude oil inventory surprise. Obviously it would impact Crude pretty strongly. But since Crude is a component of the broader energy commodity space, a big deviation from expectations would also hit Natural Gas, RBOB gasoline, and Ethanol futures as well.


And that's not all. Depending on how big the deviation was - and how big an impact it made on the broader energy space - it could also produce some price movement in equities and gold and the US dollar.


So anyone paying attention to USD and Equities after a big deviation hit the crude oil inventories would have received some important information regarding how much traders were concerned about oil supplies.


This is how professional traders, like the tweeting "NorthHeroTrading" are able to catch changes in drivers even on an intraday basis.



Over to You

With the information in this article, you can analyse and follow sentiment like a pro. Initially it may seem daunting, but it's a bit like merging into flowing traffic. Initially challenging, but once you get the hang of it, it will become second nature.


As always, direct any questions to hello@buildingatrader.com


I wish you all the best with your trading.


Justin

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