While in the long term, market valuations are driven mainly by fundamentals, in the medium and short term, market sentiment plays an important role in driving prices. Market liquidity depends on the investment community being pretty much evenly split on the outlook of an asset at the current price. That balance can be disturbed, sometimes violently, if general market sentiment changes rapidly. In the last few years, flow-driven, market making firms have retreated. They provide a buffer to the mood swings of the end investor, since their business depends not so much on the direction of the market, but on the volume of order flow, which in part is driven by those changes. Less market making capital, therefore, exaggerates the sensitivity of the market to the tides of sentiment. Given this development it is increasingly important to look for an edge in understanding the patterns of market sentiment and incorporating them into the investment process.
In this white paper we aim to show how investors can benefit from recent advances in extracting sentiment information from news flow and how to incorporate this information into their investment process to improve their return-generating ability and, just as importantly, manage their risk.
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