On average, the news stories received a rating of four, or moderately important. But the most highly rated news stories among those listed in the survey were stories about past price movements. The highest rated story was the 200-point drop in the Dow Jones Index, which scored 6.54 with individuals and 6.05 with institutions.

Price movements also affect market sentiment in other ways. Investors often feel more confident as prices rise. They feel richer as the value of their assets increases and they are more likely to spend or invest, that is, the wealth effect. The greater the level of confidence, the more conspicuous consumption becomes.

Higher asset prices and greater confidence about the future stimulate investors to borrow, increasing demand for credit. Deregulation and financial innovation also increase the supply of available credit. Credit feeds further investment, which in turn results in higher asset prices and further boosts confidence.

It’s contagious
Importantly, confidence is contagious. As market sentiment improves, more and more investors begin to feel confident – or envious of the success of other investors. At its most extreme, this leads to overconfidence or this-time-is-different thinking.

Each of these factors form part of a positive-feedback loop, multiplying the effects of investor confidence.

Of course, this pattern also works in reverse. Falling asset prices reduce investor confidence. If prices fall far enough, negative market sentiment begins to feed on itself as investors focus on negative stories.

This results in further asset-price falls, a reduction in economic activity, a shortage of credit and the possibility of a recession or even depression.

We can assess market sentiment by paying attention to the drivers and multipliers of confidence, such as stories that exemplify commonly held investor beliefs, asset prices, consumption and credit.

Daniel Grioli is an investment analyst and commentator.