If you�ve been trading awhile, you probably know there are two main forms of investment analysis � fundamental and technical.
Fundamental analysis digs into a company�s balance sheet, looking for clues to how much a stock is worth… and how much it could be worth.
What comes out is an alphabet soup of stats and ratios � P/E, EPS, ROI, EBITDA, etc. Analysts compare them against other stocks or their own projections to see if the stock is oversold or undersold.
Technical analysis, on the other hand, ignores all of that. It only cares about the stock�s price and volume. Using sophisticated charts, analysts look for certain price triggers. The terms that come out of this field are no less arcane than the terms you�ll find in fundamental analysis. Stochastics, Bollinger bands, MACD lines, etc.
But over the past few years, both fundamental and technical analysts have hit a wall. Their entire dogma is falling apart, and markets have stopped moving the way these analytical tools say they should be.
That�s because, thanks to the Internet, EVERYONE has access to this data… and everyone �knows� how the data is supposed to move prices. Free charting services not only draw technical charts for you, they also explain what the readings indicate.
Complete fundamental analysis is just a click away, too.
You can�t make money if everyone is acting on the same information in the exact same way…
That�s not to say fundamental and technical analyses are no longer valid � just that they are no longer absolute. If they were, everyone would be rich.
Instead, you have two choices � you can dig even deeper into the numbers, looking for telltale data or patterns no one knows. Or you can look at the existing numbers in a brand new way.
Sentiment analysis does both.
You see, at his core, an investor doesn�t care about a company�s earnings. Lines on a chart aren�t important to him, either.
The only thing an investor cares about is if he is making money or losing it.
And now, with everyone making decisions based on the exact same data, that emotional drive is the only thing that moves the markets.
So I�ve studied ways to literally measure emotion. I focus on two indicators � �risk appetite� and �risk aversion.� (You could also refer to them as �fear� and �greed.�)
Essentially, risk appetite / risk aversion is the root of all investment decisions. After all, there are very few safe investments out there. And the ones that are safe don�t offer big returns. As they say, greater risks mean greater rewards.
If people are feeling confident about the economy, they will feel confident buying riskier assets. That means things like stocks, foreign currencies and other volatile but lucrative investments. Greed sets in.
If there is a lot of pessimism in the air, people will likely get out of stocks and exchange their foreign currencies for things like U.S. dollars, gold or other �safe� investments. Fear takes control.
Obviously emotions can�t be tracked easily by fundamental analysis or conventional price charts. So I use some unconventional methods.
For example, I�m pioneering the use of �text mining� � analyzing the actual language used in economic reports and articles to detect potential economic trends. The result is a �word cloud� � a visual aid to how many times a particular word is used. The more times the word appears, the bigger it will be in the word cloud.
So if the word �crisis� keeps popping up in a speech � no matter the context � it will be noticeable in the word cloud… offering a sign that the policymaker wants to address investor fears. Overuse of the word �recovery� could be a codeword to spark optimism, or risk appetite.
Take a look at this word cloud I generated using a statement from Glenn Stevens, Governor of the Reserve Bank of Australia.
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