News vs. sentiment
Take a look at the chart below which shows the intraday movements in the FTSE 350 from 1 February to 2 February 2023. Overnight, the Federal Reserve decided to hike interest rates, but the communication was deemed so half-hearted that investors considered it a positive macro event and priced in less aggressive rate hikes and more rate cuts later in 2023.
Intraday performance of FTSE 350 on 1-2 February 2023
Source: Bloomberg
Now compare this to the intraday movement of the FTSE 350 the following week. Again, overnight news came from the Federal Reserve and Jerome Powell defending rate hikes rather half-heartedly and unconvincingly.
Intraday performance of FTSE 350 on 7-8 February 2023
Source: Bloomberg
It was the same overnight macro news in both instances, yet something is different. Yes, in both instances markets opened higher in the morning due to the positive news from the US while the markets were closed at night. But the follow through during the day was different. On 2 February, markets opened higher and then drifted higher throughout the day. On 8 February, markets opened higher but then gave back some of these gains as the day unfolded.
Some people would argue that on 2 February markets continued to drift higher as the Bank of England and the ECB both announced their rate hikes, thus doubling down on the Fed. But if you look closely, you can see that at the BOE and ECB announcements, markets turned lower first and then drifted higher afterwards.
And if you ask Thomas Dangl and Stefan Salbrechter from the Vienna University of Technology, this is a reflection of market sentiment on each of these days. They systematically looked at the intraday market performance of stocks in the S&P 500 after fundamental news was released overnight. The first thing that happens when markets open is that they jump higher after positive news was released overnight and lower after negative news was released. No surprise there.
However, they noticed that the follow through during the day depends on the sentiment prevailing in the market or in the stock on that particular day. If sentiment was positive and overnight news is positive, markets open higher but tend to overshoot early in the day. As the day progresses, markets then drift lower to correct this overreaction and give back some of the gains. Meanwhile, if sentiment is negative and overnight news is positive, markets open higher but then drift higher throughout the day because prices initially underreacted to the positive news.
Similarly, we can see a mirror image of this behaviour on days after negative overnight news is released. Overreaction and countertrend move if market sentiment is negative already, but underreaction and follow-through if market sentiment was positive.
Chart technicians and professional traders will likely tell me that this is nothing new but I find it good to see that we now have a study that shows that this is a systematic effect, not just something that chartists think is true based on “lived experience”.
In any case, reversing the argument allows us to create a simple assessment of market sentiment by just looking at intraday moves. Going into the Fed interest rate decision on 1 February, markets were almost certain the Fed would talk bearish, and sentiment was pretty poor. The less hawkish tone of the Fed turned out to be a positive surprise to pessimistic investors and markets initially underreacted to the news at the open in London.
Forward just one week and markets were much more optimistic about the current rally and sentiment had improved significantly because one major obstacle (the Fed) had been cleared. So now the Fed delivers the same message into a market driven by positive sentiment, and we see overreaction at the open and a share price decline intraday. What a difference a week makes.
Where does that leave us today? Well, I would say markets are still quite optimistic and we have seen further signs of frothiness, for example in market oscillators like the RSI indicating an overbought stance that is vulnerable to setbacks. Positive sentiment can carry a rally for a while but if it is not followed through by an improvement in fundamentals, it will inevitably run out of steam. So, the key thing to consider in the next 4 to 8 weeks is if fundamentals can catch up with the optimism we now see in the market. And meanwhile, you can check intraday movements to overnight news in the way I described here to quickly check if market sentiment is improving or deteriorating, positive or negative.