Investor sentiment is often a powerful force in moving stocks. It's like a pendulum swinging in a company's favor. When investors begin to think highly of your company, it might be a sign that the stock will also start heading in the right direction.

Yet knowing when investors are warming up to a stock isn't easy. Often, you can only tell after the stock has moved up -- but by then, it may be too late.

An astrolabe for investors
Investors at Motley Fool CAPS, however, have a way to monitor investor sentiment. Like every player on CAPS, each stock is given a rating from one to five stars, with five being the best. While the full "secret sauce" of how the ratings are calculated is proprietary, there are three factors that influence a stock's star rating:

  • Whether a stock is rated "outperform" or "underperform."
  • The length of time it is expected to take to achieve this performance -- a few months or a few years.
  • The ratings of the investors who make the picks.

Like astronomers scanning the skies, investors track the movement of the stars. A stock's CAPS rating trend shows what investors think about the stock over time -- whether its star rating is on the upswing or trending down.

Investors use this information to decide whether to invest in the stock. Here we're looking at companies with the lowest ratings -- one and two stars -- that have seen investor confidence upgraded one notch higher. This table lists some stocks that have seen the stars start to align for them.

Company

CAPS
Rating

Recent
Price

1-Yr Return

CytRx (NASDAQ:CYTR)

***

$3.28

98.8%

Washington Mutual (NYSE:WM)

**

$18.01

(55.9%)

RAIT Financial Trust (NYSE:RAS)

**

$8.18

(72.0%)

E*Trade Financial (NASDAQ:ETFC)

***

$4.82

(79.7%)

This is not a list of stocks to buy -- it's a starting point for further research. Yet consider the example of financial and banking titan Washington Mutual. In early November, its rating fell just as the news of its exposure to subprime lending hit. Investors were growing concerned about what the exposure would mean for profits, and the stock has bounced between one and two stars. However, CAPS investors have recently marked up the rating again, so it can still pay to keep your eyes on the stars. This time, the improvement may have more to do with valuation than with the fundamentals.

Trading on panic
Like much of the rest of the investing world, the analyst report speculating on a possible run on accounts at E*Trade caused a swift drop in investor sentiment at CAPS. Yet so brief was the decline that it's barely noticeable in the discount broker's CAPS Trend chart. Undoubtedly, investors quickly realized that it was highly unlikely E*Trade would go bust, as a rival like TD Ameritrade (NASDAQ:AMTD) might swoop in to buy out the brokerage, or the company might find an infusion of cash.

As it turns out, Citadel Investment Group has provided that infusion to the tune of $2.5 billion, easing concerns that E*Trade would fold. As it gets easier to see where E*Trade stands, CAPS players like pcmiller2 like what they see:

Well the news can't get much worse but at least they are carving out the ABS cancer. Back in my younger days my football coach used to say "what doesn't kill you only makes you stronger". I figure they ain't dead and with the announce cash infusion they have a partner that won't let them die. All the recent panic selling was due to justified uncertainty. Now that uncertainty has largely been lifted. Revenue growth rates look good up until recent quarter...P/E < 5 at this price all things considered I feel there is more upside than downside.

That seems to be the thinking behind CAPS investor AlejandroOrtiz, who gives it an outperform rating.

One analyst's unfair assessment of financial condition of this company has created a great buy in opportunity. Whether E*Trade gets bought out or not, it's an overreaction (in my opinion). Therefore, there is definitely a short term upside here and it will play itself out over the next couples of months.

Shine your starlight
We know where the bull and bear positions are, but we haven't yet heard from you. At Motley Fool CAPS every investor's opinion counts. Weighing in with yours could be the difference between these stocks becoming shooting stars or supernovas.

Considering it's free to sign up and free to post your thoughts, use this opportunity to take your star turn.

Washington Mutual is a recommendation of Motley Fool Income Investor. Sign up for a 30-day trial, and you can check out all the stock selections absolutely free.

Fool contributor Rich Duprey does not have a financial position in any stock mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.