Sentiment-Driven Investing: Are You Riding the Vibe or Valuing the Future?

by Amy | Sep 5, 2024 | Market Insight

Market sentiment is a powerful force that often drives fluctuations in stock prices and market volatility, sometimes overshadowing the actual business fundamentals. While sentiment can be a useful gauge of market mood, relying on it to make investment decisions introduces significant risks. As Benjamin Graham wisely observed, “The investor’s chief problem—and even his worst enemy—is likely to be himself.” This underscores the peril of sentiment-driven investing, where emotions and herd behaviour can lead to decisions that stray far from a company’s true value. To avoid these pitfalls, investors should consider second-level thinking—a concept championed by Howard Marks, co-founder of Oaktree Capital Management.  While first-level thinkers react impulsively to immediate events, second-level thinkers dig deeper to assess the broader implications of those reactions. In a market where sentiment can easily cloud judgement, this level of thinking becomes indispensable. Investors must scrutinise whether the prevailing market enthusiasm or fear is justified—whether soaring stock prices, driven by multiple expansion, genuinely reflect a company’s future potential, or if they have become overinflated, making the risk unattractive. Conversely, they should evaluate whether negative sentiment, triggered by macroeconomic events or a single company’s earnings announcement, has been exaggerated, leading to unjustified price declines. By mastering this understanding of market behaviour, investors can position themselves to have the market serve them, rather than being misled by its emotional swings.

The Double-Edged Sword: When Sentiment Becomes the Market Driver

Multiple expansion is often a sign of sentiment-driven investing. As an example, where a company’s price-to-earnings (P/E) ratio increases not due to improved fundamentals but because investors are willing to pay more for each dollar of earnings. This can lead to inflated share prices that are not a true reflection of the company’s actual performance. Nvidia (NASDAQ: NVDA), a leader in the semiconductor industry, serves as a textbook example. Although Nvidia’s fundamentals are robust, its share price has surged largely due to multiple expansion fueled by investor enthusiasm for its pivotal role in emerging technologies such as artificial intelligence and gaming. However, this sentiment-fueled rise has pushed Nvidia’s valuation to potentially unsustainable levels, posing a risk to investors buying at these elevated prices. Conversely, negative sentiment can lead to undervaluation, where a company’s share price is unfairly depressed due to broader market fears. This scenario often unfolds during market downturns, where panic selling drives prices down across the board, regardless of a company’s fundamental strength.. The Oracle of Omaha, Warren Buffett, has long advocated for buying during such periods of irrational pessimism, famously stating, “Be fearful when others are greedy, and greedy when others are fearful.” Historically, there have been numerous instances where strong companies were unduly punished by negative sentiment, creating buying opportunities for contrarian investors. For example, during the initial stages of the Covid-19 pandemic many high-quality companies were sold off in the panic. When there was so much unknown investors were quick to take money off the table, only for share prices to recover and thrive in the subsequent years.

The Perils of Timing the Market Based on Sentiment Alone

One of the most perilous aspects of sentiment-driven investing is the temptation to time the market based on fleeting emotions. As discussed earlier, positive sentiment can lead to FOMO where investors chase after hot companies or sectors, often buying in at peak prices. Though this strategy might deliver short-term gains, it carries substantial risks. The upside of each investment becomes more and more limited as multiples expand. As market sentiment shifts, these potentially overvalued shares can experience sharp declines, leaving investors with substantial losses. The long-term impact of an investment decision peak sentiment (and multiples become detached from reality in either direction) could be devastating for both your portfolio and your investing mindset. Investors who succumb to FOMO can find themselves in a position where they must sell low during market corrections, locking in losses and potentially derailing their financial goals. In contrast, a contrarian approach to investing—buying when others are selling and selling when others are buying—has proven successful over time. This strategy is based on the understanding that markets often overreact to both good and bad news. By going against the crowd, contrarian investors can potentially capitalise on the market’s misjudgments. Studies indicate that companies bought during periods of low sentiment and market downturns tend to outperform in the long run. Similarly, selling during periods of high sentiment can help investors avoid the pitfalls of market bubbles. It’s easier said than done. When markets turn it often goes against everything your mind is telling you to buy into a declining market. Investing is difficult, and timing the market is even more challenging.

Lessons from History: The Impact of Sentiment on Investment Outcomes

History is replete with examples of how sentiment can push markets to extremes. The tech bubble of the early 2000s is a classic case where investor enthusiasm for internet companies pushed valuations to unsustainable levels. Companies like Pets.com, theGlobe.com and eToys saw extreme price movements, often being valued based on page views and projected revenue rather than actual revenue and profitability. Despite the initial hype, these companies struggled to generate sustainable income and eventually collapsed. As the bubble burst, trillions of dollars in market value was wiped out. The lesson is clear: while sentiment can be an investor’s ally, it can also become a trap, especially for those who fall into the cycle of buying high and selling low. For second-level thinkers, the focus should be on discerning what is truly driving market or individual stock prices. Is sentiment working in your favour, pushing your investments higher, or is it presenting an opportunity where prices have become disconnected from long-term business fundamentals? By grounding decisions in thoughtful analysis and questioning whether an investment is rooted in solid fundamentals or merely riding a wave of excitement, investors can cultivate a mindset that remains steady amidst market noise. Achieving long-term outperformance often requires a different approach from the majority. By thinking and behaving differently from the crowd, investors can leverage sentiment to their advantage, rather than being led astray by it.

The TAMIM Takeaway

In a sentiment-driven market, it’s easy to be swept up by the excitement of soaring prices or the panic of sudden downturns. So, how do you successfully navigate these emotional tides? The most successful investors are those who rise above the noise, employing second-level thinking to evaluate the true value of their investments, regardless of the market’s current mood. As Howard Marks wisely pointed out, “You can’t predict. You can prepare.” By maintaining a focus on long-term fundamentals and resisting the temptation to follow the crowd, investors can skillfully navigate the complexities of sentiment-driven markets and position themselves for sustained success. In the end, the key to thriving in today’s investment landscape isn’t about riding the wave of sentiment, but about accurately valuing the future and making informed, thoughtful decisions.