Wednesday, July 7, 2010

Does Sentiment Support A Double-Dip?

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Whether the financial markets and the economy will experience a double dip seems to be the million dollar question right now. Even though sentiment analysis may not fully answer this, it can certainly provide a glimpse on what’s crossing investor minds at the moment.

To gauge market sentiment, I construct a “US Sentiment Index” which probes the news sentiment of companies comprising the S&P 500. Using RavenPack's proprietary news analytics technology, the US Sentiment Index examines the language and events disclosed across thousands of news articles in real-time.

Out-of-sample back testing since 2005 shows the index clearly highlighted the risk that U.S. equities were sliding into a bear market, suggesting the indicator can help predict turning points as much as 3 months in advance.

FIGURE 1: US Sentiment Index vs. S&P500 Cumulative Returns

After a slight 3 point drop in March, the US Sentiment Index rose for 3 consecutive months this year signaling an improving mood in the market. For June 2010, the index rose above 74 points for the first time since August 2007, hitting 77. The last time the index reached such level, the S&P 500 rallied over the next 12 months.

The recent increase in the US Sentiment Index is supported by improving news in June across all sectors. Over the past 3 months, the strongest build up in sentiment is on the Utilities Sector, followed by Telecoms and companies providing Basic Materials. Although still positive, the sentiment around Consumer Goods and Technology companies appears to be the lowest.

TABLE 1: Sector ranking based on 90-day sentiment changes (As of June 30, 2010)

I plan to update this information on a monthly basis for those that care to follow it.

In the meantime, I continue to investigate new methods to construct sentiment indicators using news analytics.