Sentiment Trading and the Limits of Knowledge

While value investors examine companies’ financial data and future outlook, most short-term investment strategies now incorporate some sentiment analysis insights. Rather than analyzing the long-term ability to create value of a company, quantitative traders recognize that investor sentiment is the primary driving factor of short term price fluctuation. Far from the perfect competition assumption of all information being perfectly absorbed and reacted upon by the market, investors react in imperfect shocks to news articles and tweets. This insight is verifiable enough that the most advanced traders rely on it for their main source of income. Traders rely on the fact that short term shocks are almost random, and simply try to react faster than everyone else. Their difficulty beating the market suggests that any central bank would need unlimited freedom to act quickly if it was to actually mitigate a shock before it happened. Quantitative traders are often less interested in the long-term evaluation of stocks, because the choices of business owners are more difficult to predict and profit from than the short term jolts of investors. Interventionist central banks miss this insight and attempt to promote long-term growth by enabling short-term access to credit. While pumping money into the market is often able to increase short term growth, central banks should remember that long-term growth is not a product of monetary policy, but rather an inherently unpredictable walk enabled by stable institutions and predictable money. Short term fluctuations are heavily controlled by immeasurable and irrational sentiments, and long term growth is most possible in the stability that is stripped by central bank intervention.  

Quantitative traders know that anything but instant reactions are too slow for short-term arbitrage. Even second by second data is often not enough to react to recent news headlines, particularly with so many other quantitative traders using sentiment-based tools of analysis. The moment news articles are published about specific companies, AI tools analyze the content of the article and instantly buy or sell stock. They are constantly attempting to predict investor reaction and buy before the information has been fully reacted to. While nothing fundamentally about a specific company may have changed, a small shift in people’s view of it can have massive effects on share price. Short term fluctuations are based so strongly on sentiment that it is difficult to engage in smoothing because any number of perceived market factors can undo or accelerate monetary interventions.

Instantaneous, sentiment-based traders, recognize that the long-term value of specific stocks is not determined by sentiment, and that longer time horizons allow for much greater stock price variance. However, the speed and near randomness of short term fluctuations means that it’s difficult to accurately beat the market, even with the most advanced tools. To expect that the Fed, an organization that is intended to be transparent and slow, can somehow offset sell offs and recessions caused by fear and other unpredictable factors is a fantasy. Unless the Fed were to take an authoritarian technocratic strategy to rule, it wouldn’t be possible for them to come close to smoothing macroeconomic fluctuations like they want to. Even with this potential embrace of technology and speed, there would be an unmanageable potential for malinvestment and overreactions. The unpredictability of bringing the Fed’s attempts at smoothing the market into the 21st century might present even more problems than help. 

If short term fluctuations cannot possibly be managed by a central bank without a descent into technocracy, and long-term economic growth is created by risky processes of trial and error, there is no room for a central bank to do anything but create a stable currency. The responsibility to control the unemployment rate and the associated markers of recession has repeatedly been used to justify failure at the Fed’s primary job of stabilizing the Dollar. While fiat currency is a bad idea in itself, stepping away from the main task of ensuring its stability is always a recipe for disaster. Quantitative traders bet their lives on the short term being erratic, and the long-term being unpredictable, but the Fed simply keeps proving their point by contradicting them. stable institutions with fair property rights and a stable monetary system are the core of economic growth, and the central bank must be vigorously questioned whenever they override those priorities.