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Investor Sentiment as a Contrarian Indicator

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Last week, when the American Association of Individual Investors released its latest investor sentiment survey, it reached a milestone of sorts. With the market still facing high levels of volatility and uncertainty, those reporting themselves as bullish on equity investments have now dropped to 22.2 percent. Bullishness hasn’t been in such short supply in nearly two years, since August of 2010. The AAII sentiment reading fell eight percentage points in a single week, posting its largest weekly decline since April 12.

Why is that a milestone? The Bespoke Investment Group has studied the bullish readings, and found that when the survey drops more than one standard deviation below the long-term average, the market rallies 78.7 percent of the time. When it’s two standard deviations below average, over the subsequent six months, the market has rallied every single time.

With last week’s drop, we’re now more than one standard deviation below the long-term average. So if history is any guide, we’ve got about an eight percent chance that the market will go up in the next six months.

Canny market watchers have known this for a long time: If you want to know when the market is about to turn, look for investor sentiment to reach one extreme or the other. The high point for people showing a bearish outlook in the AAII survey was reached on March 5, 2009, when a whopping 70.3 percent of the respondents said they had a negative outlook on the stock market. This was six months after the Bear Stearns and Lehman Brothers meltdowns sent the entire economy into a tailspin, and the S&P had lost 45 percent over that time frame.

We all know what happened next. The very next day, the S&P reached its bottom, and began turning back northward. Since the day that sentiment was at its most negative, the S&P has returned nearly 100 percent.

It works the other way, too. The AAII survey reached its bullish peak on January 6, 2000 just as the dot-com bubble was cresting. At that point, a full 75 percent of the investors surveyed were optimistic about the future of stocks. That bull market had a little bit longer to run, but it started its decline by September of 2000. Within a year of the 75 percent reading, the S&P 500 was off by 7.1 percent.

There isn’t a pure tradeoff between bulls and bears in this reading, since a sizable number of those surveyed always report themselves as neutral. So even though bearish sentiment peaked in 2000, the record for the lowest number of investors reporting themselves as bulls was reached way back on November 16, 1990, just after Iraq invaded Kuwait and we were poised to enter the first Gulf War. At that point, just 12 percent of investors reported themselves as bulls. Over the next 12 months, the S&P 500 gained more than 25 percent.

The AAII survey, as well as other investor-sentiment readings, has long served as a fairly reliable contrarian indicator. An analyst with BofA Merrill Lynch, Savita Subramanian, compiles an index of her own, measuring the forward-looking sentiment of Wall Street strategists. The Wall Street Journal reported earlier this month that Subramanian’s index had fallen to its lowest level in 15 years, meaning that strategists were more bearish now than they had been even during the depths of the financial sector collapse and the Great Recession. Subramanian, of course, takes this as a strong buy indicator.

There are other measures out there that take a different approach to appraising sentiment. One interesting tack is taken by the monthly Dow Jones Economic Sentiment Indicator, which uses a proprietary algorithm to scan 15 major American newspapers and measure the relative optimism in their reporting on the economy. The methodology is entirely independent from a survey, yet the results are often the same: The Dow reading dropped in June (July’s isn’t out yet), marking the third straight month of declining optimism.

If you’re looking to the AAII survey as an indicator, remember, in historic terms more investors tend to be bulls rather than bears. Over the long term, the average bullish sentiment sits at 38.8 percent, while the average bearish sentiment is 27.9 percent. Almost exactly a third of investors, or 33.4 percent, have historically taken a neutral position. So to find those times when sentiment gets out of whack, remember that investors are commonly bullish.

But the best use of sentiment as an indicator is found at the extremes. In the current environment, the number to watch for looks like 19 percent. That would be two standard deviations lower than the historic average, and according to the figures compiled by Bespoke, when it reaches that level, stocks have rallied every single time over the next six months, and by double digits.

For more from Tom Nawrocki, see:

Listening to the Whisper Numbers

Rise of the Mega-Caps

Problems in the Fund Business