Stockscores Analysis of Stocks

Optimism vs. Pessimism

Do you think you judge information differently, based on your state of mind? A person in a bad mood who receives good news will likely react differently than a happy person receiving the same information. How we judge information is dependant upon our mood, and since the stock market is a collective of individuals judging information, understanding the mood of the market is important to predicting stock price change.

In the late 1990's and in to the first quarter of 2000, the market was in a very good mood. Federal Reserve Chairman Alan Greenspan characterized it as "irrational exuberance" in a speech he delivered. The effect of this extreme optimism about stocks was that company fundamentals were awarded a very high valuation. Stocks traded at astronomical multiples to company earnings, because investors were enjoying strong stock market gains and were willing to pay more. Everyone was having a party.

Ultimately, the bubble of exuberance burst, and stocks tumbled lower. Three years later, the market was gripped in an extremely bearish stock market, where investors were very unhappy with their returns. Many stock market participants became so fed up that they opted out of the stock market, choosing real estate and other investment vehicles instead. Pessimism was at an all time high.

gn="justify"> In the strictest theoretical sense, stock price is based on the ability of a company to make money in the future. This means that information about the company's business and its ability to make money defines what stock price will be. However, while most theorists argue that company fundamentals drive stock price, I will assert that it is only the perception of fundamentals that matter.

"justify"> Since our perceptions are shaped by our psychology, our perception of company fundamentals is dependant both on information about the company and by the state of the market's collective mind. How the market judges fundamentals will depend on the mood of the market.

Simply put, the market can either be optimistic or pessimistic about a stock, a business sector or the market in general. Successful traders will tend to buy optimistic stocks, and sell pessimistic stocks. By doing the same, you can put one more factor in your favor.

Think of the market's mood as a river. A stock is like a canoe on the river, and its future price direction is determined by how strong the company can paddle. Even a good company that paddles hard will have a difficult time if it is working against the current. It will always be easier to paddle with the current, and we as investors should do the same.

lign="justify"> Optimism and pessimism are easy to see on a stock chart, simply by drawing some lines. Look at the bottoms on the chart, the lower boundaries of price troughs. If they are rising over time, the market is optimistic. Pessimism exists when the tops, price peaks, are falling. Rising bottoms is optimism, falling tops are pessimism.

The Stockscores can also be used to determine whether the market is optimistic or pessimistic. A Sentiment Stockscore of 60 or better generally means that investors are Optimistic. If the Sentiment Stockscore is less than 60, investors are likely pessimistic. I tend to only buy stocks that have a Sentiment Stockscore of 60 or higher.

Utilizing optimism, pessimism and the Stockscores in your trading will help you improve your market performance. The StockSchool Pro home study training course goes in to greater detail about these important concepts, and shows specific strategies that you can use to identify good trading opportunities. See the Educational Products area of Stockscores.com for more information.