Consider this scenario:
A company goes public. It receives a flood of attention on Facebook and Twitter in the days leading up to its IPO. After the social media blitz, its stock fizzles, and a little later, a study emerges showing that -- coincidence? -- most of those posts and tweets had been negative.
Failed companies are nothing new to the stock market. What is new, however, is social media -- a platform where general public opinion, positive or negative, is available for all to read.
Following a long line of bizarre beat-the-market strategies, a new theory has emerged that suggests tweets and status updates can be used to foresee a company's fluctuations on Wall Street. Is it crazy enough to work?
The Study That Started It All
A paper out of Indiana University analyzed millions of Twitter posts in relation to the Dow's performance from August to October 2008. According to its findings, the amount of tweets that were categorized as "calm," or lacking in extreme emotion, matched up with the Dow's turns three days in advance, with 86.7% accuracy.
In short: The market rose when there were a lot of calm tweets, and fell when there weren't.
It's hard to deny the overlap here, but let's not forget that the period from August through October 2008 was a time of Wall Street panic. Public attention to the Dow was particularly high, so more people were tweeting about it. This likely gave the study much more information than it would have had under everyday circumstances. After all, it isn't every day that #StockMarket is a trending Twitter topic, so this could impact the Social Media-Stock Market Movement theory's long-term overall effectiveness.
This Theory Could Be Right
One of the most vocal supporters of the study is Paul Hawtin, who created the world's first "Twitter hedge fund," Derwent Capital Management. The fund monitored company stock performance side-by-side with social media "sentiment" and picked stocks based on its findings. The fund was only in business for one month, and in that time its overall 1.86% returns outpaced both the market at large as well as the average hedge fund's performance.
Hawtin shut down DCM so he could revamp it into a trading platform that provided "sentiment analysis" to the run-of-the-mill investor. The new model is just a few months away from launch. In the meantime DCM has provided a graph charting the "Twitter sentiment" linked to another high-profile Wall Street tweet fest: the IPO of Facebook (FB).
Source: Derwent Capital Website.
As shown on an infographic on Derwent Capital's website, from May 18 to Aug. 17, 2012, general Facebook sentiment seemed to move in step with the company's performance as a stock. When sentiment dropped, so did the stock, and when it rose, it was a good day for investors.
But does that mean you should fire your broker and start analyzing your mini feed?
This Theory Could Be a Lot of Hooey
If there is one lesson the stock market has taught us time and again, it is that no one single principle is ever completely consistent or reliable. Not the Efficient Markets Theory, not the Random Walk Theory, and certainly not this budding new Social Media Theory.
The only rule here is that there are no rules, and a star can rise and fall in the blink of an eye, without explanation. This is part of what makes the market so exciting to follow.
Statistics, formulas, and market-busting mathematics can be thrown around until everyone is blue in the face, but ultimately this social media guessing game is one that is likely to lose. For one thing, these charts and graphs rely on buzzwords that are completely subjective. Whether a tweet is "happy," "sad," or "calm" can be twisted whichever way the Great and Powerful Chart Maker wishes, and who's to say it knows when a tweet is sarcastic?
The SEC is well aware of the potential dangers in using social media for investing purposes. It has issued numerous warnings about social media's tendency to be "landscape-shifting," and has threatened legal action against any advisor who abuses the platform for their own financial gain. In short, this method of stock picking is extremely volatile.
Still want to analyze charts, graphs, and formulas to your heart's content? Stick with numbers that are proven to correlate with a company's performance: its financial statements. A glance-over of a business's debt, free cash flow, and net income will give you a much better idea about a company than knowing how many people have "liked" it.
Social media stats may provide an interesting new perspective, but they should, at best, be supplemental to the rest of your research.
Motley Fool contributor Caroline Bennett does not own shares of any company mentioned here. The Motley Fool owns shares of Facebook. Motley Fool newsletter services have recommended buying shares of Facebook.