Notes

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• We provide this short-term forecast of investor sentiment as an example of our perspective on stock market corrections and recoveries and our algorithmic forecasting models. 
• We provide clients with multi-month forecasts and strategy sessions followed by periodic status reports. 
• We also offer technology transfer engagements for those wanting to make physics-based sentiment forecasts in-house.

This report shows the market index price along with two sets of sentiment-related indicators, covering the past 52 weeks and offering forecasts for the upcoming weeks. The price of the market index (e.g., S&P 500 Equal Weighted, DJIA) is shown on a logarithmic scale, using weekly observations. The scale is omitted for simplicity.

Introduction 

Our sentiment framework recognizes two broad forces affecting investor sentiment:

• Economic forces. Economic forces shape investor views on economic conditions and market fundamentals. For convenience, we consider behavioral patterns to be economic forces. Individuals seek to maximize economic gain and minimize regret. 
• Natural forces. Natural forces have a meaningful impact on investor sentiment and this is our focus. As implausible as it sounds, a 2003 working paper by the Federal Reserve Bank of Atlanta concluded that solar energy variation has a significant impact on investor emotion and stock returns. We call our measures of solar energy variation "Physics-Based Sentiment Drivers." They are statistically significant in explaining the variability of price momentum metrics for major stock indexes. 

The report shows two sets of sentiment indicators:

• Market Resilience Index®  (MRI) series for the stock index. These are shown in the upper panel of the report.
• Physics-Based Sentiment Drivers that influence market prices and the MRI. The drivers are shown in the lower panel.

The MRI capture broad investor sentiment by reflecting the impact of economic forces and natural forces. The physics-based drivers reflect only the naturally occurring forces. Thus, the drivers predict when investors are likely to put an optimistic or pessimistic spin on news and events positively, while the MRI shows the extent to which they have done so. These two sets of indicators are calibrated to one another. They tend to become more synchronized during times of economic stress and crisis and we watch for them converging on a negative trend, as noted in #4 below. 

#1. Market Resilience Indicator (MRI) Series (Upper Panel)

The MRI series is derived solely from index price changes, measuring return acceleration over periods ranging from a few weeks to several quarters. These indexes help identify sentiment inflection points, signaling optimal short-term and long-term opportunities for entering or exiting the stock market.

• Micro MRI (brown line): This indicator highlights shorter-term price trends, typically lasting several weeks. The Micro MRI most closely tracks the week to week moves of the market.  It moves cyclically, and its slope/trend and level are key indicators. Its level is indicated by score ranging from a low level of 0 to a high value of 100. The score and slope (positive or negative) are shown in the legend. A trough at a low level signals a strong short-term buying opportunity, while a peak at a high level suggests a strong short-term selling opportunity.
• Macro MRI (light blue): This indicator tracks long-term trends in index prices, typically lasting several quarters. Like the Micro MRI, and its slope/trend and level are key indicators, with the current status shown in the legend. A high level followed by a shift to a negative slope typically signals an impending long-term downtrend.
• Exceptional Macro MRI (dark blue line above the Macro MRI): This indicator appears when the slope of the Macro MRI is likely to become more positive, signaling increasing market resilience. Its current status is indicated in the legend (Yes=present, No=not present). When present, the Exceptional Macro can reduce the negative impact of  pessimism associated with a declining Micro MRI. When the Exceptional Macro disappears, the Macro MRI may remain positive but experience a decreasing slope. After being present for a long period, the market often falters briefly when the Exceptional Macro ends, but then resumes its positive long-term trend. 

In general, the market is resilient, recover quickly from negative news, and move higher when two of the three MRI are indicating resilience. See this page for background on the development of the MRI.

#2. Drivers of Naturally Occurring Shifts in Sentiment and Market Resilience (Lower Panel)

We identify four physics-based resilience drivers that forecast periods of naturally occurring investor optimism and pessimism. These drivers operate independently of economic and market factors but significantly influence investor behavior, explaining over 70% of the variation in commonly used price momentum measures, such as the 14-week RSI. Their impact is particularly pronounced during times of economic and market stress, often indicating the future direction of the MRI. An early sign of market stress is the convergence of the MRI with their corresponding physics-based drivers. 

A key feature of these drivers is that we can forecast them several months into the future. The drivers do not predict news and events. Instead, they forecast likely human reaction to news and events. Naturally occurring optimism magnifies investor response to good news. Naturally occurring pessimism magnifies the response to bad news. The forecasts are shown in the light green box in the lower right of the chart. 

• Long-Term Driver (purple): Forecasts long-term gradual shifts in sentiment that significantly affect the Macro MRI and longer cycle MRI. Low points signal periods of natural pessimism, making markets more vulnerable to declines, especially when investor views on economic factors are also pessimistic. 
• Short-Term Driver (red): Predicts short-term gradual sentiment shifts that influence the Micro MRI and short-term price changes. Low points indicate greater market vulnerability. Above and below the Short-term Driver we show  green lines, which we call confirmation lines. The confirmation lines indicate periods when market prices are most likely to be affected by the Short-Term Driver, which can help us discern its impact in real time. These lines indicate when components of this driver are moving in unison. One of the major components is the 14-week RSI. 
• Flash Driver (yellow): Identifies times when gradual changes in investor sentiment and market resilience are disrupted, often resulting in sudden market movements. There is a strong correlation between the market index price change and the multi-week disruptions identified by the Flash Driver.
• Minor Flash Driver (rose): Detects brief bursts of optimism or pessimism. Though statistically insignificant over our multi-decade test period, it is often associated with abrupt market moves when investor views on economic forces are neutral or negative. This driver is also useful when combined with other indicators such as the MRI or other resilience drivers. On its own, it may trigger a short-lived trend. This driver was formerly known as the "Expected Noise" driver.

The first three are most important in assessing the future resilience of the stock market. If all three indicate pessimism, the market is likely to be very vulnerable to price declines and slow to recover from declines that occur for economic reasons. The abrupt episodic sentiment shifts indicated by the Flash Driver often supersedes the first two.  The weekly forecasts of the Flash drivers tend to be more accurate than those of the Long- and Short-Term drivers.  

#3. Monitoring the Gap

To accurately assess investor reaction to economic forces, we monitor the gap between actual and predicted sentiment metrics, which helps us strip away the effects of naturally occurring forces. For example, the Physics-Based Driver reflects only natural forces, while the corresponding Market Resilience Index reflects both natural and economic forces. The difference between these values reveals the strength and direction of the economic forces at play.

• A small gap indicates that sentiment related to economic factors is neutral.
• A large gap between actual and predicted metrics suggests that economic forces have a more significant impact on overall investor sentiment:
  • A large negative gap indicates negative sentiment driven by economic factors.
  • A large positive gap indicates positive sentiment driven by economic factors.

#4. Early Warning: Convergence

Within this framework, an important early indicator of a potential market correction is when two key conditions are met. The first and most critical condition is a downward trend in a long term indicator such as the Long-Term Physics-Based Driver, signaling a period of naturally occurring vulnerability, or the Macro MRI (as was the case in 2007/8). 

The second condition is when other MRI or RSI begin to track or converge with those negative trends. 

When the Long-Term Driver indicates upcoming vulnerability and the MRI converge with the driver, there is minimal positive sentiment beyond what is expected from natural forces, leading to little economic optimism to counterbalance the negative trend. It also indicates that active traders are becoming more influenced by natural emotional shifts and less by economic forces. Together, these two conditions imply that investors are likely to overreact to negative news and may engage in panic selling.

The figure below shows the convergence of the MRI (green line) to a corresponding physics-based driver (blue). The driver is known several months in advance and we monitor price action, often the MRI, to determine if it will converge with the negative trend of the driver. The early warning of developing convergence occurs at the point marked A.  

The figure below shows a market condition in which the economic forces are strong and positive. No convergence is apparent.