How to measure investor sentiment and how you can profit from this?

Closed-end funds

Individual investors are the primary owners of these funds as opposed to institutions.

Institutions such as mutual funds don't buy shares of closed-end funds or other mutual funds because their customers don't like the idea of paying two sets of fees,.

We can postulate that individual investors would be more flighty than professional investors, such as pension funds and endowments, and thus, they would be subject to shifting moods of optimism or pessimism ("investor sentiment").

When individual investors are feeling perky, discount on closed-end funds shrink and when they get depressed or scared, the discounts get bigger.


Small companies

Individual investors are also more likely than institutional investors to own shares of small companies.

Institutions shy away from the shares of small companies because these shares do not trade enough to provide liquidity a big investor needs.



How to measure individual investor sentiment?

So, if the investor sentiment of individuals varies,  it would show up both in the discounts on closed-end funds and on the relative performance of small companies versus big companies.

That is exactly what was found.  The average discount on closed-end funds was correlated with the difference in returns between small and large company stocks; the greater the discount, the larger the difference in returns between those two types of stocks.



How to profit from this investor sentiment variability?

The strategy of buying the closed-end funds with the biggest discounts earned superior returns (a strategy also advocated by Benjamin Graham).  Burton Malkiel, author of A Random Walk Down Wall Street, has also advocated such a strategy.

Market Sentiment Explained

DEFINITION of 'Market Sentiment'

The overall attitude of investors toward a particular security or larger financial market. Market sentiment is the feeling or tone of a market, or its crowd psychology, as revealed through the activity and price movement of the securities traded in that market. For example, rising prices would indicate a bullish market sentiment, while falling prices would indicate a bearish market sentiment. Market sentiment is also called "investor sentiment" and is not always based on fundamentals.

INVESTOPEDIA EXPLAINS 'Market Sentiment'

Market sentiment is important to day traders and technical analysts, who use technical indicators to attempt to measure and profit from the short-term price changes often caused by investors' attitudes toward a security. Market sentiment is also important to contrarian investors, who like to trade in the opposite direction of the prevailing sentiment. For example, if everyone is buying, a contrarian would sell.

Read more: http://www.investopedia.com/terms/m/marketsentiment.asp#ixzz3Ztxa2YLw 
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Market Sentiment

Market sentiment is the general prevailing attitude of investors as to anticipated price development in a market.  This attitude is the accumulation of a variety of fundamental and technical factors, including price history, economic reports, seasonal factors, and national and world events.

For example, if investors expect upward price movement in the stock market, the sentiment is said to be bullish. On the contrary, if the market sentiment is bearish, most investors expect downward price movement. Market sentiment is usually considered as a contrarian indicator: what most people expect is a good thing to bet against. Market sentiment is used because it is believed to be a good predictor of market moves, especially when it is more extreme.  Very bearish sentiment is usually followed by the market going up more than normal, and vice versa.

Mutual fund flows are very useful.

Market sentiment is monitored with a variety of technical and statistical methods such as the number of advancing versus declining stocks and new highs versus new lows comparisons. A large share of overall movement of an individual stock has been attributed to market sentiment. The stock market's demonstration of the situation is often described as all boats float or sink with the tide, in the popular Wall Street phrase "the trend is your friend".

In the last decade, investors are also known to measure market sentiment through the use of news analytics, which include sentiment analysis on textual stories about companies and sectors. Market sentiment, as such, might be acquired from more than one sentiment analytical tool. For example, there could be just simple extraction of movement on stock exchange and validly called market sentiment. Another tool is to extract the news and media information based on their polarity. Yet another sub-subject might be community sentiment about the market movements (blogs, forums).

The Acertus Market Sentiment Indicator (AMSI) is one indicator of market sentiment. AMSI incorporates five variables. In descending order of weight in the indicator they are 

-  Price/Earnings Ratio, a measure of stock market valuations; 

-  price momentum, a measure of market psychology; 

-  Realized Volatility, a measure of recent historical risk; 

-  High Yield Bond Returns, a measure of credit risk; and 

-  the TED Spread, a measure of systemic financial risk. 

Each of these factors provides a measure of market sentiment through a unique lens, and together they may offer a more robust indicator of market sentiment.

Additional indicators exist to measure the sentiment specifically of retail Forex market investors. Though the Forex market is decentralized (not traded on a central exchange),  various retail Forex brokerage firms publish positioning ratios (similar to the Put/Call ratio) and other data regarding their own clients' trading behavior.  Since most retail currency traders are unsuccessful,  measures of Forex market sentiment are typically used as contrarian indicators.

http://en.wikipedia.org/wiki/Market_sentiment