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What Is the Daily Sentiment Index (DSI)?
Every investor wishes for a crystal ball so they can see where the markets are headed. But while one hasn’t been invented (yet), there are ways traders can predict market movements by gauging market sentiment. After all, so much of the investing world is driven not by data but rather by emotion and expectations.
One reliable indicator is the Daily Sentiment Index (DSI), created in 1987 by market analyst Jake Bernstein. This index is designed to gauge sentiment in the futures markets. Since futures markets operate after hours, analyzing their movements is one way to tell where the broader stock market might open. The DSI is known as a leading indicator because it predicts future movement based on current data.
Short-term traders in particular use sentiment indexes like the DSI to understand where the market is trending so that they can hop aboard the appreciation potential that comes along with the trend. This is known as momentum investing.
- Bull markets, which are defined as expansionary periods in the economic cycle, feature more buyers than sellers, and the trend is up. Here, traders buy long, or purchase common stock with the expectation that share prices will rise.
- Bear markets, which are defined as periods of post-peak economic contraction, happen when the stock market declines and assets lose value. Here, there are more sellers than buyers, and bearish derivatives strategies like buying put options rule the day.
How Does Sentiment Trading Work?
Traders believe that by having a firm grasp of sentiment, they will also be able to tell when a trend is shifting—and thus devise ways to profit. For example, when the reading on the Daily Sentiment Index is high, that means market expectations are bullish. This is often seen as a contrarian signal that the market (or a sector, or an asset) has peaked and that prices could be headed lower soon.
Warren Buffett is one of the world’s best contrarian investors. He bought shares of The Washington Post company, valued at $80 million, during the bear market of the 1970s. He later sold his shares to Amazon for a cool $250 million in cash.
Buffett believes that trends and short-term volatility should matter little to buy-and-hold investors. He encourages investors to examine company fundamentals like P/E ratios and practice value strategies like buying stocks that are trading below their intrinsic value. He famously said, “Be fearful when others are greedy, and greedy when others are fearful,” which is a hallmark of contrarian investing. This practice has made Buffett one of the greatest—and richest—investors of all time.
How Is the Daily Sentiment Index Calculated? What Is the Average Score?
The DSI assigns numeric values describing sentiment on futures, currencies, and Treasury securities. Its readings are based on raw data as well as 3, 5, 9, and 18-day moving averages. A reading of 1 is extremely low, while 100 is extremely high. 50 is the dividing line: Sentiments above 50 are considered to be bullish, while anything under 50 is bearish.
In addition, readings above 85 or below 15 usually point to a top or a bottom, indicating that a trend could be about to shift in the opposite direction. The longer the indicator remains at a high level, the more prolonged the expected decline, and vice versa.
One key difference between the DSI and other indicators is its timeliness: its readings are available within one hour of the market close.
How Do You Use Sentiment Analysis in Investing?
Earnings often drive growth, but understanding that the markets don’t always move rationally is another key lesson wise investors learn—often the hard way.
John Maynard Keys, a 20th-century economist, wrote at length about speculation, or emotion-driven buying and selling. These actions are based on herd mentality or, a phrase Keys coined, called animal spirits.
He believed that when people rely on instinct and feelings to make decisions, their ability to act rationally becomes distorted. Therefore, when we magnify this impulse by many thousands if not millions of times for every investor trading the markets, personal emotion can actually fuel market phenomena such as market bubbles, run-ups, selloffs, and even recessions.
What Are Some Other Sentiment Indexes?
The Daily Sentiment Indicator is a fee-based annual subscription service. Other sentiment indicators that are available for free include the following:
- The VIX Volatility Index, created by the Chicago Board of Exchange and available on its website, measures S&P 500 index options and is used to benchmark broader market volatility. It’s also known as the fear index because the higher the reading, the more volatile the trading environment. This index is updated daily.
- The CNN Fear/Greed Index, available on the CNN website, is a compilation of seven different market indicators: momentum, stock price strength, stock price breadth, put and call options, junk bond demand, market volatility, and safe-haven demand. This index is updated as data is published, which means there is often a lag.
- Put/call ratios are another way to measure market sentiment. Rising put/call ratios mean the market is bearish because investors who purchase put options believe the price of the underlying asset will fall. Inversely, falling put/call ratios are a bullish signal.
- Moving averages illustrate how many stocks are trading above or below a threshold over a certain period of time, such as 50 days and 200 days. When a stock “crosses over” these averages, that means sentiment has changed. Moving averages are usually listed along with a stock’s fundamentals on trading platforms.
Should Long-Term Traders Watch Daily Sentiment?
Long-term investors don’t need to lose sleep over near-term opinions—that’s the beauty of buy-and-hold investing. But if they are seeking short-term profits, then following sentiment indicators can be a useful tool in their trading arsenal.
TheStreet.com’s Ellen Chang believes that not following the crowd can also pay off in spades. She discusses why investors should perform their own due diligence on stocks, even when they’re in a hot sector and the company just posted strong earnings.
