The sentimental vista
There are any number of ways to define, or interpret, sentiment. As with many definitions and interpretations, this can depend on context. For financial markets, which are multivariate and deep, the context and its drivers, the resulting definitions and interpretations, are like a mosaic — personal, social, geographical, political, historical, economic, industrial, educational, speculative — and it’s all speculative, really. The markets are a network system in which clusters form or dissipate, to varying degrees, to build or shrink the sentiment of an idea in its particular time.
In a narrow finance sense, a definition that may be most closely suited to the subject is the discounting of risk at the risk-free rate. One acts upon a view as though the risk of being wrong can be ignored. This is sentiment.
It isn’t that the risk is left unrecognized, necessarily, or that the belief is necessarily held strongly. Rather, the substance of the view, the risk, the discount rate, are all inconsequential: The sentiment is positive or negative all the same.
Counterintuitively by this definition, sentiment is indiscriminate, and in a sense almost dispassionate. If anything, it may be caught like a contagion and transmitted, muted or destroyed.
The preceding describes sentiment in pure form, and while financial markets are never free of sentiment, they are rarely purely sentimental. Though individual investors may well be.
Still, there are times when sentiment climbs to an escalated level to take a more dominant position in the market’s varied stance. And there are times, like now I think, when sentiment seems like the major driving force. Perhaps because there is so little substance to support the market flows, or, more correctly, because substance is in a state of what appears like never-ending change…
Businesses are changing, industries are changing, economies are changing, society is changing, and now, perhaps, biologies and ecosystems, too. It is quite difficult — no, it’s impossible — to see what happens on the other side of transformations and rebuilding and disruption at such monumental scale.
What follows is a thesis, not advice; the difference cannot be overstated.
- Many believe that excesses of sentiment were rooted in the individual investor community after the economic collapse of early-2020. This may be true, but it also feels like the contagion spread more broadly to the bigger money, which is likely to continue until the varied levels of uncertainty subside.
- Sectors and established categories, small caps and large caps, growth and value, are increasingly dubious distinctions outside of sentiment, which can have reflexive consequences; and the rotations, ups and downs of these throughout the year that’s passed has set the tone of movements going forward.
- Price action and market trends in many cases have been and will be justified by finance fundamentals after the fact, as anything can be when there’s a will and a creative spirit… when sentiment is in actuality the driver; to draw general conclusions from the particular case will thus require caution.
- All this poses special challenges for investors: (1) Sentiment is difficult to forecast. (2) Spotty, often capricious, and uneven, sentiment is difficult to hedge. (3) Sentimental correlations are unstable, and so portfolio construction becomes inordinately problematic.
- Spilling over from the elements above, alternative new markets will come into their own, where price has been and always will be built on sentiment unabashedly; for instance, art, collectibles, and other assets where financial metrics play no role at all.
- One such alternative new market, which has already started to explode, individually for the first few years but now also institutionally, is cryptocurrency; the explosion will continue, driven by sentiment.
- The most successful investors will be successful at anticipating market sentiment (and its changes) during an investment period; by necessity, therefore, investment periods will shorten at one end of the barbell, where change in sentiment is easier to grasp, and lengthen at the other end, where sentiment, over the long run, is more likely to settle down and meet with fundamentals on a common ground.
- Over the course of time, the markets (which are always right, by definition) will incorporate the acts, extremes and fickle patterns of sentiment into an analytic system, to expand upon legacy methods of financial evaluation and economic forecast; this may not happen as quickly as next year, considering the dense complexity that underlies.
But it will… Because every fantasy book needs a map. Sometimes several.
Reinterpreting the networks (2020)
If it’s not a bubble (2018)
Interpreting the networks (2017)