I've read quite a bit about investment theory over the years. There have been thousands of papers written about how to value a stock. Thousands of other papers detail how to value the stock market.
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And one of the biggest things I've learned from all my reading is that none of those papers provide everything an investor needs to know.
This research has led to the development of many models that can be used to determine a stock's fair value. But the market price is usually above or below that value. Recently, there has been some interesting research into why the market price is different than the fair value.
Economists are noticing that sentiment is a factor in the current market price. In other words, whether investors are bullish or bearish is a factor in the current market price of stocks and the overall stock market.
This seems obvious to investors. But, the academic community seems to have been slow in recognizing this fact, probably because it is impossible to quantify.
While I can't quantify sentiment, I can explain the idea with a formula:
Market Price = Fair Value * Sentiment Factor
So, when investors are bullish, the market price of a stock or an index should be above its calculated fair value. The sentiment factor, in quantitative terms, would be greater than 1 in this example. Sentiment could also be less than 1, which would indicate that the market price is less than the calculated fair value.
Solving that formula with precision would probably result in a Nobel Prize. But fortunately, we don't need to solve this formula to profit from it. We just need to know whether the sentiment factor is greater than or less than 1.
We've been in a bull market, and the sentiment factor is greater than 1 in this environment. So, stocks should be overvalued right now.
But I believe the sentiment factor is declining. The decline in sentiment is probably due to the news and to our current political situation. You don't have to follow politics to know that it's an emotional topic. All of that emotion spills outside of the political arena and into society.
Declining sentiment doesn't necessarily create a bear market, but it does reduce the odds of making profitable trades in overvalued stocks -- which is most stocks at the moment. That's why I keep returning to a few favorites that offer value in the current market. These are stocks that offer safety.
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This article originally appeared on StreetAuthority.com.