Sentiment Speaks: The Reason This Market Is Baffling Everyone

After writing about this issue now for 12 years, I know I have made an impact based upon all the notes, emails, direct messages, and comments which thank us for changing people’s lives, with this recent comment from a client being typical of what we see:

“Sometimes I wonder if EWT is for real or is some kind of a dream . . . thank you again for changing my life.”

Yet, when I read comment sections in various articles, I realize there's still a lot more work to do to open people’s eyes as to how sentiment affects market and stock movements.

This past week, I saw the following comment in an article:

“Supposedly the market was hinging on AAPL, AMZN, MSFT, GOOGL earnings. So what I don't get is how weak or vague guidance is being overlooked. Other stocks got hit by -10% to -35% for that same weak or vague guidance. Why did the mega caps get a pass? Why did the market actually rally into weakness? I can only guess nobody is paying close attention. That will happen after earnings season?”

Another commenter answered the first claiming that nothing makes sense other than “manipulation.” And, I just rolled my eyes at these two comments.

The first question that popped into my mind was what happened to critical thinking? If your belief as to what drives the market turns out to be wrong, should this not drive you to look deeper into what does drive the market? Would that not make more sense than falling back upon some specious perspective which you cannot prove?

Now, if you want to be intellectually honest about this issue, please feel free to read an article I wrote a few weeks back which outlined exactly why one should not base their investment decisions upon earnings:

Sentiment Speaks: How To Use Earnings To Increase Stock Market Returns

For those who do not wish to read that very detailed article, I will summarize it by saying that many studies have been done over the past four decades which explain why trying to invest based upon earnings is not likely going to prove helpful at the major market turns. While the market is in a trending move, earnings will likely coincide with the market trend. But when the market or a stock turns, the earnings will likely lag for some time before they begin to trend again and align with the market. As I explained in the article:

“During a negative sentiment trend, the market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course after reaching an extreme level, and it's time for sentiment to change direction, the general public then becomes subconsciously more positive. You see, once you hit a wall, it becomes clear it's time to look in another direction. Some may question how sentiment simply turns on its own at an extreme, and I will explain to you that many studies have been published to explain how it occurs naturally within the limbic system within our brains.

As Alan Greenspan once noted:

“It's only when the markets are perceived to have exhausted themselves on the downside that they turn.”

When people begin to subconsciously turn positive about their future (which is a subconscious – and not conscious – reaction within their limbic system, as has been proven by many recent market studies), they're willing to take risks. What is the most immediate way that the public can act on this return to positive sentiment? The easiest and most immediate way is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and earnings have turned.

In fact, historically, we know that the stock market is a leading indicator for the economy, as the market has always turned well before the economy does. This is why R.N. Elliott, whose work led to Elliott Wave theory, believed that the stock market is the best barometer of public sentiment.

Let's look at the same change in positive sentiment and what it takes to have an effect on the earnings and fundamentals. When the general public's sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, thereby having an immediate effect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, and those take time to secure.

They then put the newly-acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they're then able to provide more goods and services to the public and, ultimately, profits and earnings begin to grow - after more time has passed.

When the news of such improved earnings finally hits the market, most market participants have already seen the stock of the company move up strongly because investors effectuated their positive sentiment by buying stock well before evidence of positive fundamentals is evident within the market. This is why so many believe that stock prices present a discounted valuation of future earnings.

Clearly, there's a significant lag between a positive turn in public sentiment and the resulting positive change in the underlying earnings of a stock or fundamentals of the economy, especially relative to the more immediate stock-buying activity that comes from the same causative underlying sentiment change.

This is why I claim that fundamentals and earnings are lagging indicators relative to market sentiment. This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive-mood effects on a business-growth cycle. It's also why those analysts who attempt to predict stock prices based on earnings fail so miserably at market turns. . .

By the time earnings are affected by a positive change in social mood, the social mood trend has already been positive for some time. And this is why economists fail as well – the social mood has shifted well before they see evidence of it in their "indicators."”

Furthermore, the article above also provides empirical evidence from market history which clearly shows that earnings and stocks do not always move hand-in-hand, and sometimes with dramatic divergence.

Ultimately, I will implore each and every person who reads my article to learn more about the effect that market sentiment has on the directional movements of stocks as well as markets. The great majority of the time, sentiment will offer you a much better indication of the direction of a stock as compared to earnings.

You see, while earnings may be a catalyst to a stock move, it’s the underlying sentiment which will provide the “spin” as to the directional movement of that stock. This is why we often see stocks move in the opposite manner of the reported earnings or projections/guidance.

With this perspective in mind, please re-read the quote above from the commenter, with which I began this article. It should now make a lot more sense if viewed within the light we tried to shine upon it within this article.

Now, to quote Forrest Gump:

“That’s all I have to say about that.”