Sentiment Analysis: The Third Leg of the Table
Some of My Favorite Sentiment Indicators for Individual Stocks
An Example of a Stock That Fits These Parameters
Over the last few months, my monthly contributions to Cabot Wealth Advisory have focused on ways to use options and ways to lower risk. One of the simplest ways to use options is to buy a call option on a stock that you think is going to go higher or to buy a put option on a stock that you think is going to go lower. But how do you determine which stocks to buy calls and puts on?
Most people use either fundamental analysis or technical analysis. Fundamental analysis includes things like price-to-earnings (P/E) ratios, return-on-equity (ROE) and earnings per share (EPS) growth. Technical analysis involves chart pattern recognition; it consists of things like moving averages, overbought/oversold indicators and support/resistance levels. But there is a third form of analysis and that is sentiment analysis.
Sentiment analysis is the least-used analysis method, but it may be the most useful. Quite simply, the reason a stock or the market goes up is because there are more buyers than sellers and the reason a stock or the market goes down is because there are more sellers than buyers.
Studies of market sentiment can help investors determine when it’s likely that there will be more buyers than sellers and vice versa. Look at it this way: If everyone is bullish on a stock and owns the stock, who’s left to buy the stock? If every analyst has a “buy” rating on the stock, how can there be an upgrade?
Each analysis style has a time period in which it works better than the other analysis styles. With short term trades like we recommend in Cabot Options Trader, technical analysis is the primary driver behind the recommendations. Because these recommendations are only open between 10 and 15 days, the fundamentals and the sentiment don’t have time to have much of an affect on the stock. Fundamentals can have an affect in the short term if there is news like an earnings announcement, but the everyday movements of the stocks are based more on technical factors than anything.
Sentiment is more useful for long-term analysis. When the sentiment towards a stock reaches a bullish or bearish extreme, investors are not going to switch sides en masse, but rather they will shift gradually. If everyone is bearish towards a stock and the company announces great earnings, you might have a few analysts change their ratings toward the stock, adding fuel to the fire. If the stock starts climbing, short sellers will have to cover their positions by buying the stock, adding another layer of buying pressure.
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Now that you know why sentiment works, let’s look at some sentiment indicators. Because sentiment analysis isn’t as prevalent as technical analysis or fundamental analysis, there aren’t nearly as many indicators to look at. There are different indicators for individual stocks and for the overall market, but today I’ll focus on the indicators for individual stocks.
I mentioned my two favorite indicators previously: the short interest ratio and analyst ratings. The short interest ratio measures the number of shares sold short divided by the average daily volume of the stock. For instance, if 10 million shares of ABC Corp. are sold short, and the average daily trading volume for ABC is two million shares, the short interest ratio is 5.0. We consider anything above five to be relatively high when it comes to short interest ratios.
The theory behind how a short interest ratio helps is based on possible short-covering rallies. If a stock has a high short interest ratio and the stock suddenly starts climbing, short sellers must buy the stock to close their positions. The greater the number of short sellers who are trying to cover their positions, the more buying pressure they are going to exert as they attempt to close their positions. Since there isn’t such a thing as a long-covering sell-off, the short interest ratio works best for finding bullish situations.
Analysts ratings, conversely, can also work for both finding bullish or bearish opportunities. We are all familiar with the “buy,” “hold” and “sell” rating system analysts use. Looking at a stock’s overall analyst ratings gives you an idea how likely it is that a stock will get an upgrade or a downgrade simply based on how many buy or sell ratings the stock already has. For instance, if ABC Corp has 15 analysts following it and 14 out of the 15 have it rated as a “strong buy” and one has it rated as a “buy,” the likelihood of ABC getting an upgrade is very slim. The opposite is true as well, if all 15 analysts have the stock rated as a “sell” or worse, it isn’t likely that the company will receive any further downgrades.
Ideally, you want to find a stock with solid fundamentals, an upward trend on the chart and a degree of pessimism from analysts and short sellers.
Astoria Financial (AF) is a savings and loan based in New York with 85 branch offices. AF has a short interest ratio of 9.2 with 7.55 million shares sold short according to the latest report. This is a pretty bearish level of short interest, which is good from a contrarian standpoint. Analysts are bearish as well, with three analysts rating the stock as a “sell,” 11 analysts rating the stock as a “hold” and three analysts rating the stock a “buy.”
Based on this sentiment, you would think the company was performing poorly, but when we dig into the financials of the company we find a different story. In its most recent earnings report, Astoria Financial showed year-over-year quarterly earnings growth of 192%! The quarterly revenue growth on the same basis was up 36% and the company has an operating margin of 36%.
Looking at the chart, we see that AF has been in an uptrend since the market lows in March 2009. The trendline formed by the lows over the last two years provides a layer of support and it is close to the same level as the 20-month moving average. The recent weakness in the overall market is providing an opportunity to enter a trade on AF at a better price.
Given the bearish sentiment toward Astoria Financial, combined with the positive fundamentals and the upward trend in the price, I can see the stock going up 50% or more in the next 12-18 months.
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