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Sentiment Analysis and Its Role In Investing: Now and In The Future

Facts are important and eventually play out in the longer term. The cold logic of numbers wins the day. But Sentiments and Narratives, which are at times detached from cold facts, can also be important. The relative impact of facts and sentiment depends on how quickly they spread. For a researcher working on the latest drug discovery, the relevant time scale is at least a few years long before her discovery can reach the commercial production stage. There are checks and balances at each and every step and the facts determine the final results. In a different context, the same thing may not apply to the direction of funds for research. For example, how much money a particular research problem will attract can depend more on sentiment and less on its actual importance. 

When the time scale is short, the sentiment can matter more than the facts. In stock markets when the reaction time needs to be quick and the trade decision has to be made immediately after the event, the fund manager lacks the luxury to do it at leisure. The sentiment, i.e. the first impression, can matter more in this case and the price impact can be seen very quickly after a good or bad event. The quicker you are, the better chance you stand to benefit from material developments which will impact the stock price. 

This phenomenon gets explained differently in different situations in markets and the economy. There have been several instances in the past when “shortages” actually get worse because everyone thinks there is a “shortage”. Similarly, if the company is in the news for the wrong reasons for a while, the reaction of media is negative to even a positive development. The momentum of positive and negative sentiment is indeed extremely powerful. 

 

In his book, “Narrative Economics: How Stories Go Viral & Drive Major Economic Events”, Robert Shiller, a Nobel laureate, offers many examples on how a narrative becomes something everyone start believing. The most important thing which you learn from this book is that, in certain situations, facts hardly matter. The markets is a prime example. How it is a sure sign that you should exit when every ‘non-expert’ becomes an expert and there are stock tips coming even from the unlikeliest of places. The “Narrative Economics” talks about similar interesting examples from the stock market. 

Take the example of a market crash. Even a small change in sentiment can quickly become big, and almost immediately, everyone starts selling. The situation has evolved at a rapid pace in the previous two decades. With powerful and cheaper machines now and most sophisticated tools available for data analysis, the process has become even faster. This is not just true for sharp moves (flash crashes); even on a longer time scale, sentiment is playing a much bigger role now in regular market movements and decisions to ‘buy’ or ‘sell’. No news goes unnoticed, every tweet gets analysed, the social media feeds are continuously scanned for anything which is material for price movement. Our own analysis at EMAlphashows clear correlation between sentiment in the Indian equity market and equity returns. 

These changes are irreversible, and we venture to speculate that in the future sentiment analysis will become even more important and relevant. There are arbitrage opportunities available for fund managers who don’t ignore these insights and while being right will always remain important, being quick in sentiment detection will be equally important for generating superior investment returns. Human beings are always attracted towards stories than pure numbers or data which is boring. As long as this basic premise remains valid, sentiment analysis and discovery of news which can move markets will remain useful for market participants.

Research Team
EM Alpha LLC

For more EMAlphainsights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data on Emerging Markets for better investment decisions, please send us an email at research@emalpha.com.

About EMAlpha:

EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious.Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.

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