Thursday, September 17, 2009

Construction of Simple Investment Strategies Using News-Based Market Sentiment Indices

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Recently, I conducted a study on how to construct market sentiment indices based on news sentiment. The applied methodology was presented in a previous posting: "Construction of Market Sentiment Indices Using News Sentiment" from August 5th, 2009.

Generally, no single definition of investor sentiment exists. Still, most discussions involve (a) investors optimism or pessimism about stocks, (b) beliefs not justified by fundamentals, or (c) misevaluation by some investors. Since investor sentiment is not directly observable, researchers have employed various measures of sentiment. Proxies include the closed-end fund discount, mutual fund redemptions, the volume of initial public offerings, ratio of odd-lot sales to purchases, consumer and investor survey data, technical indicators, and the proportion of fund assets held in cash. In addition to these sentiment proxies, a range of economic indicators are available of which some are considered part of different governments official list of leading indicators.

The indicators that make reference to sentiment, are mainly generated from surveys and address consumer sentiment. The release schedule for these indicators are often either monthly or quarterly, making them less timely than the news sentiment indices that I suggest as part of my research. News sentiment indices are more timely because they are continuously calculated in a consistent manner from real-time media coverage.

In the U.S., examples of sentiment-based economic indicators include the Conference Board Consumer Confidence Index, the University of Michigan Consumer Sentiment Index, and the Washington-ABC News Consumer Comfort Index. While in Europe, examples include the German IFO Business Climate Index, and the French Business Sentiment Index. All of the mentioned proxies and indicators try to capture market-wide sentiment rather than sentiment at the individual company level. I propose using news sentiment in order to capture not only market-wide sentiment focusing on specific indices, but also to use news sentiment to construct company level sentiment indices (which is the focus of my current research).

The key findings of my studies on market sentiment indices can be summarized as:
  • Relevance matters. The role of the company in a given story has to be taken into account as this improves the correlation between the sentiment index and the out-of-sample stock returns by a factor 2.5+. This indicates that considering only key word matching or simply counting stories that mention companies is flawed.
  • More stable investment strategies. Constructing simple sentiment-based trading rules, going long (short) sentiment index values greater (lower) than 50, seem to create more stable strategies outperforming momentum-based investment strategies based on the market index itself.
  • Attractive correlation levels. For the market sentiment index covering the Dow Jones Industrial Average, correlations between the sentiment index values and the two week forward-looking returns range between 20 - 27% applying a three month news aggregation window. For the Eurostoxx50 sentiment index, the corresponding range is 9 - 15%.
  • Attractive Hit ratios. Applying a three month news aggregation window, I arrive at Hit ratios ranging between 59 - 65% and 55 - 67% for the DJIA and Eurostoxx50 sentiment indices, respectively; this with Profit/Loss ratios ranging between 1.01 - 1.27, and 0.86 - 1.18.
In Figure 7 and 8 of the study, I have included the cumulative performance of the sentiment-based investment strategies that yield the highest level of correlation to the relevant market index returns.

It should be noted that the lead time indicates after how long an investment decision is implemented in the market. That is, with a lead time of 95 business days, the investment decision made on the sentiment index value today is not carried until 95 business days from now. The news sentiment aggregation window refers to how far back we consider the sentiment of news stories when constructing the current sentiment index value. Both figures consider a two week investment horizon.

The above results are based on sentiment data including April 2009. To present the most recent development of the market sentiment index on the DJIA. I have included the below figures that considers data including August 2009.

Interestingly, it can be observed that the sentiment levels have improved significantly especially in the second quarter of 2009; and is currently at levels that have not been seen since mid-2006, the period before the last bull market.

While more research can be done to refine the methodology and to translate the sentiment index values into actual trading or investment signals, the above results highlights some potentially interesting and profitable relationships between news sentiment and market returns. The full results of my findings are documented in the paper Construction of Market Sentiment Indices Using News Sentiment (August 28, 2009).