Quick Answer
Sentiment indicators gauge whether the broad market is overbought or oversold. Contrarian indicators like the put/call ratio, short interest, and the VIX read extremes against the crowd, while confirming indicators like trading volume and market breadth validate the trend already in place.
Moving from individual company analysis to the broader market, sentiment indicators help gauge whether the overall market is bullish or bearish. These indicators play a key role in investment timing decisions.
What Is Market Sentiment?
- Market analysis uses quantitative indicators to gauge overall market direction
- These indicators are either contrarian (go against the crowd) or confirming (validate the current trend)
- The key question: Is the market overbought (due for a decline) or oversold (due for a rally)?
Key Market Indicators
| Indicator | What It Measures | Bullish Signal | Bearish Signal |
|---|---|---|---|
| Put/call ratio | Volume of puts vs. calls | High ratio (excessive bearishness = contrarian bullish) | Low ratio (excessive bullishness = contrarian bearish) |
| Short interest | Total shares sold short | High short interest (potential short-covering rally = contrarian bullish) | Low short interest (less pent-up buying pressure) |
| Trading volume | Number of shares traded | Rising volume confirms an uptrend | Declining volume suggests a trend is weakening |
| Market breadth (advance/decline) | Advancing vs. declining issues | More advancers than decliners confirms bullish trend | More decliners than advancers confirms bearish trend |
| Mutual fund cash levels | Cash held by mutual funds | High cash = buying power available = bullish | Low cash = fully invested = less buying power |
| VIX (Options volatility) | Expected market volatility | High VIX = fear/uncertainty (contrarian: market may be oversold) | Low VIX = complacency (contrarian: market may be overbought) |
| Index futures | Futures on market indexes | Premium to cash index suggests bullish expectations | Discount to cash index suggests bearish expectations |
- Market momentum describes the speed and strength of a price move; it is a confirming signal, read through the same tools as trading volume and market breadth (rising volume and broad participation confirm strong momentum, while narrowing participation signals fading momentum)
Contrarian vs. Confirming Indicators
This distinction is frequently tested on the exam.
Contrarian Indicators
Contrarian indicators assume the crowd is wrong at extremes. When most investors are pessimistic, contrarians see a buying opportunity (and vice versa).
- Put/call ratio: High ratio = everyone is buying puts (bearish) = contrarian signal to BUY
- Short interest: High short interest = many investors betting on decline = potential for a short-covering rally (bullish)
- VIX: High VIX = extreme fear = contrarian buy signal; Low VIX = complacency = contrarian sell signal
- Mutual fund cash: High cash levels = funds hold buying power on the sidelines (contrarian bullish); low cash levels = funds are fully invested (less buying power)
Exam Tip: Gotchas
- The put/call ratio and short interest are contrarian indicators. A high put/call ratio means most investors are bearish, which contrarians interpret as BULLISH (the crowd is usually wrong at extremes).
- Low VIX means complacency, not safety. Contrarians see it as a warning that the market may be overbought.
Confirming Indicators
Confirming indicators validate the direction of the current trend.
- Trading volume: Rising volume in an uptrend confirms the trend is healthy
- Market breadth: More advancers than decliners confirms a broad-based rally
Exam Tip: Gotchas
- Trading volume is a confirming indicator, not contrarian. Rising volume validates a trend; declining volume suggests the trend is weakening.
How Are the Major Market Indexes Built?
Major market indexes are benchmarks for overall market direction and portfolio performance:
| Index | Composition | Weighting Method | Key Feature |
|---|---|---|---|
| DJIA (Dow Jones) | 30 large-cap stocks | Price-weighted | Oldest and most recognized; higher-priced stocks have more influence |
| S&P 500 | 500 large-cap stocks | Market-cap-weighted | Most widely followed benchmark for the broad market |
| Nasdaq Composite | All Nasdaq-listed stocks | Market-cap-weighted | Heavily weighted toward technology |
| Russell 2000 | 2,000 small-cap stocks | Market-cap-weighted | Benchmark for small-cap performance |
- Price-weighted (DJIA): A stock's influence is based on its share price, not its total market value
- Market-cap-weighted (S&P 500, Nasdaq, Russell): Larger companies have more influence
Exam Tip: Gotchas
- The DJIA is price-weighted (not market-cap-weighted like the S&P 500). A higher-priced stock has more influence regardless of company size.
- The Russell 2000 is the standard small-cap benchmark. The S&P 500 and Nasdaq Composite are large-cap benchmarks.
What Should You Check on Exam Day?
- Put/call ratio, short interest, VIX, and mutual fund cash levels are contrarian; trading volume and market breadth are confirming.
- A high put/call ratio or high VIX reads bullish to a contrarian; low VIX is complacency, not safety.
- The DJIA is price-weighted; the S&P 500, Nasdaq Composite, and Russell 2000 are market-cap-weighted.
- The Russell 2000 is the standard small-cap benchmark.