Why Investor Sentiment is Important

We’ve all heard of financial metrics. First, there are the fundamental metrics that analysts love to cite, such as EV/EBITDA, debt ratio, earnings per share, payout ratio, and growth rate. Then there are technical stock metrics that many market technicians like to bring up, such as the 200 day simple moving average, 100 day simple moving average, or overbought/oversold metrics. Then there are miscellaneous metrics such as hedge fund holdings, and executive option expiration dates that can sometimes yield valuable insight.

While all those metrics can be useful, one metric is in plain sight – investor sentiment – and is often overlooked. In terms of its impact, investor sentiment is arguably one of the most important metrics, especially as it pertains to short squeezes. Let’s go deeper.

Why Investor Sentiment is Important

Investor sentiment is important because it can cause self-fulfilling prophecies. Self-fulfilling prophecies are things that come true if enough people believe in it.

A bank run, for example, is an example of a self-fulfilling prophecy. In the pre-FDIC insurance days, even if a bank is in sound financial condition, if enough people believe the bank is about to fail, the bank would fail because people would withdraw more and more money out until the bank ran out of its liquid holdings. If that happened, the bank’s fundamentals could take a major dive if it couldn’t find liquid holdings to meet its needs.

There are self-fulfilling prophecies in the stock market. If investors are bullish and enough people buy, the stock will go up. If investors are bearish and enough people sell, the stock will go down.

How Investor Sentiment is Measured and How it Pertains to Short Squeezes

Investor sentiment, which is often measured by momentum and technical indicators (such as whether a stock’s price is above the 200 day SMA, 50 day SMA, etc) along with data such as taking scientific polls of major fund investors of a stock, can help investors better estimate how a stock will react if a certain news event occurred. Paying attention to the relevant stock opinion of highly respected/followed twitter/stocktwits veteran users can also help gauge professional opinion to a degree as well.

In terms of examples, say XYZ stock just released earnings, and investor sentiment is really bullish. If the earnings report is really good and the float is highly shorted, XYZ shares could potentially surge and cause a short squeeze. If investor sentiment is very bearish, any news that isn’t good could sent shares of XYZ lower meaningfully.

As it pertains to short squeezes, traders do need to pay attention to investor sentiment for another reason. If investor sentiment is really bearish, XYZ is highly shorted in relation to its float, and XYZ releases a blowout report or something totally unexpectedly good occurs, XYZ shares could be more likely to undergo a short squeeze.

Disclosure: no positions

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