How Market Sentiment Drives Stock Prices

Timing the Market by Watching Sentiment Shifts

Marcus Padley | 11 June 2024 | Education Corner

High Correlation Between Bitcoin and the NASDAQ

You might be aware in the crypto space that there is a high correlation between Bitcoin and the NASDAQ. The correlation is logical. Bitcoin has no fundamentals; it is priced on sentiment alone. It is, unlike almost any other price, based 100% on sentiment. And the NASDAQ index is the embodiment of the rolling US market sentiment towards risk, technology, and the equity markets. The daily NASDAQ barometer drives risk-on and risk-off sentiment, and Bitcoin is all risk. So it is highly correlated.

And the same sentiment waves are washing over Australia.

The Influence of NASDAQ on Australian Tech Stocks

Talk to the Investor Relations departments at any big Australian technology-related (growth) company, and they will tell you that whatever they do, there is one thing that they cannot control as a company or an Investor Relations department, and that is the correlation the share price of technology-based businesses have with the NASDAQ. Here is the REA Group’s (REA) share price overlaid on the NASDAQ.

It is the same with a lot of our stocks. If the CEO rings up the Investor Relations department and asks, "Why is the share price up X?" and "Why is the share price down Y?" the answer is, on a day-to-day basis - "Have you looked at the NASDAQ overnight?"

The Impact of Sentiment on Stock Prices

In the current market, where the fortunes of US Big Tech companies carry the whole US market, the fortunes of the NASDAQ also carry the sentiment for a host of technology-related stocks in the Australian (and global) markets. When stocks are on high PEs and low yields, sentiment is terribly important. Share prices do not reflect value alone; they are part value and part sentiment at all times. And growth stocks are more sentiment than value because growth stocks fail most traditional fundamental filters. But still, they go up and down. Why? Because of swings in sentiment.

The Double-Edged Sword of Sentiment

And sentiment cuts both ways. When the market goes down, the sentiment-dependent stocks get clobbered. But when the market bottoms, sentiment-driven stocks are the stocks to buy for a rapid recovery because they reflect mood, enthusiasm for the market, risk, growth, and, unlike fundamentals, enthusiasm can be generated in a blink. So sentiment-driven stocks are more volatile, dangerous, risky, and, if you can time them right, offer vastly more opportunity on the way up.

Correlation Between NASDAQ and Australian Growth Stocks

Sentiment is the biggest swing factor for many stocks, and sometimes the market mood, trend, sentiment is more important than the fundamentals. So if we take the NASDAQ as the indicator of sentiment, we should see some correlation between the NASDAQ and some of our growth stocks (sentiment-dependent stocks). Let's have a look. These charts show some of our technology-related stocks plotted over the NASDAQ. When you are looking at these, there is a bit of a trick. Correlations do not mean the two prices track each other; it means they turn at the same time - the magnitude of the rises and falls is not the point. It's the timing of the turning points you look for. Some lines may diverge despite being highly correlated. Here are a few - some might surprise you.

Lessons from Sentiment-Driven Stocks

A few lessons from this observation:

• Share prices are part fundamentals and part sentiment.
• Share prices do not reflect fundamentals alone as some blinkered investors think.
• Stocks that fail fundamental filters rely more highly on sentiment.
• High PE, low yield stocks include a higher element of sentiment.
• Growth stocks rely on sentiment.
• Sentiment-driven stocks are more volatile.
• Sentiment-driven stocks offer more growth and opportunity.
• If you can time sentiment-driven stocks, you will make a lot more money compared to investors relying on traditional fundamental measures.
• Sentiment changes much more rapidly than fundamentals.
• You cannot use fundamentals to time stocks.
• The most obvious sentiment indicator is the overall market trend.
• Sentiment swings are much faster and drive much bigger share price movements than fundamental swings.
• Sentiment is fickle - it represents the herd.

The Value of Understanding Sentiment in the Market

There is a lot of money to be made objectively watching and exploiting the herd. Bottom line, when there are big pivot points in the market, sentiment-driven stocks offer much more risk and opportunity. If you have a low-risk profile, avoid sentiment-driven stocks. If you are vigilant, decisive, objective, and have a higher risk profile (offset by higher vigilance), then sentiment stocks will offer you a lot more volatility, opportunity, activity, risk, and "fun."

Quantifying Sentiment in Your Stocks

Work out which of your stocks are sentiment-driven (high PEs and no PEs) and which offer the most risk if the market tops out. I'm sure I could build an algorithm that quantified the level of sentiment involved in every Australian stock price and develop a Fundamentals and Sentiment Rating:

• Telstra would be 80-20. 80% fundamentals and 20% sentiment.
• Banks would be 90-10.
• Bitcoin would be 0-100.
• Seek would be 40-60.
• REA would be 30-70.
• Wisetech would be 20-80.

You get the idea. What are the ratios on your stocks?