Measuring trust in the markets

“The market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning and yet in a sense legitimate where no solid basis exists for a reasonable calculation.” Nearly one hundred years ago, John Maynard Keynes understood the impact – then as now - of emotions and sentiment on financial markets. In fact, the price dynamic can be seen as a manifestation of group psychology, oscillating between optimism and pessimism, between unconditional trust and sudden skepticism. And corresponding with these emotional extremes, prices can roller coaster - unexpectedly skyrocketing or abruptly plummeting.

Very often what triggers these movements is not only objective information but emotions as well, and along these lines, the way people’s emotions can be mutually contagious. From this perspective, market movements can be considered the outcome of a change in terms of what the majority of market players believe will occur – a change motivated by new information which isn’t necessarily verified or true, along with the emotions that information elicits, which tend to propagate throughout the market. So social factors take on critical importance in explaining financial dynamics as well as the trust that people come to have.

Herding behavior: This term describes how the group can affect the behavior of the individual, especially in case of uncertainty. The behaviors that emerge on the markets resemble those of ‘the herd’: individuals tend to conform and do what everyone else is doing, even if it’s wrong. In fact, in the face of uncertainty, people hesitate to make decisions for themselves for fear of making a mistake; they’d rather trust the judgment of the group, which feels like the safer option when there’s risk of error.

But this type of approach can easily lead to superficial evaluations, which are clearly less than optimal. For example, some studies show that even with complete information on market trends in hand, even expert investors tend to follow prevailing market opinion, even if that means they don’t fully leverage what they know. At the heart of these behaviors lies the tendency to assimilate information unquestioningly from the external environment: from personal contacts, the predictions of analysts, and mass media. But in doing so, the potential distortions are incalculable. Let’s take mass media as an example. Information sourced here can be imprinted with ideology bias (which intentionally seeks to influence readers’ opinions), or spin bias (the tendency to exaggerate the facts, sensationalizing stories to generate buzz). But for financial markets these are dangerous inaccuracies which can dramatically shape the trust of investors and consequently dictate how they allocate their investments.

With the influence of this external conditioning on individuals comes ‘groupthink’, which in turn generates what appears to be irrational repercussions on the stock market and stock prices. The trust (or mistrust) of market players toward individual companies, and the markets in general, can be interpreted as a reflection of collective processes that transcend individual cognition.

The set of factors, perceptions and distortions that can trigger this dynamic is vast, which makes it nearly impossible to assess accurately. Yet relevant research has identified certain indicators that can contribute, at least in part, to evaluating the real degree of market trust. In fact, by using sentiment indicators, we can measure the positive or negative expectations of a certain type of investor (professional asset manager, trader, saver) with respect to market prospects. The methods for measuring market sentiment are myriad. Some are based on opinion polls asking consumers, savers, institutional investors, and bloggers about their optimism or confidence in the economy or financial markets. The Crash Confidence Index is based on similar data, compiled from interviews asking for predictions on the risk of a possible market crash in the next six months. This index in some ways actually foretold the 2008 crash, when the percentage of optimists dropped to reach a minimum in January 2009.

Nowadays, with the proliferation of available data and data processing technologies, the internet and social media can be sourced to develop indicators for measuring sentiment. For example, analysts can monitor what’s trending on Twitter to pinpoint the positive or negative emotions underlying tweets (such as calm, worried, confident, energized, polite or happy). The idea is to try to understand where the financial markets are headed. In addition to overt trust indicators, there is also a second, more widely-accepted category based on trends. Among the innumerable examples, some may seem quite bizarre. For instance, one popular alternative indicator is the ‘Crane Index’: the more the big construction cranes we can see, the greater the economic growth around us and hence the more confidence in the economy. Another long-standing trust indicator for the City in London is the ‘Champagne Index’: how much bubbly is consumed in certain bars is seen as a reliable measure of trust among market players. Of course, there are more traditional parameters as well that are generally linked to trends in the US stock market, which is still the most influential in the world today.

Sentiment indices can provide useful indications on the level of trust in the market, in terms of trends and prospects. But today, there’s another more basic question, the question of trust in the market itself. In a recent survey, for example, over half of the interviewees from 27 different countries said they thought that any player in the banking sector wouldn’t hesitate to take advantage of them if given the opportunity. In light of this widespread mistrust, rebuilding public opinion in the financial system becomes an inescapable issue, to prevent irrational group behaviors that could be detrimental for everyone, behaviors such as excess caution in asset management.