Why You Should Ignore the Masses

 |  Includes: DIA, IWM, QQQ, SPY
by: Lou Basenese

I know that James Surowiecki achieved "bestsellerdom" in 2004 by telling us that there's wisdom in crowds. That, collectively, humans make much more informed decisions than individuals. What a total crock! (At least when it comes to investing.) As Humphrey B. Neill observed, "When everybody thinks alike, everyone is likely to be wrong." And there's no better proof of this than investor sentiment.

As I shared in July 2012, when bullish sentiment hits extreme lows, stocks almost always rally. Well, guess what? Bullish sentiment just cratered.

Bulls Run Scared

Every week, the American Association of Individual Investors (AAII) measures investor sentiment. And the latest bullish sentiment reading ranks as nothing short of jaw dropping. It plummeted 45%, from 35.5 to 19.3. That's the largest weekly drop in over a decade, folks. What gives? I mean, stocks just hit another record high, and suddenly investors don't feel bullish at all?

So much for embracing the notion that the trend is our friend. Here's what you need to know… I've said it before, and I'm sure I'll say it again - when virtually no one is optimistic about the stock market, that's all the more reason we should be bullish. Just take a look at the data and tell me you disagree…

As you can see, when the AAII bullish sentiment reading drops below 25% during the current bull market, stocks (almost) always rally over the next three and six months. Of course, the latest reading is way below 25%, which got me thinking about what happens when we get really extreme lows. So I went ahead and analyzed the data all the way back to 1987 - the year AAII started tracking sentiment.

My findings are equally compelling. (But only for those of us with the guts to be contrarians and ignore the "wisdom" of crowds.)

More Evidence You Should Ignore the Masses

Since 1987, bullish sentiment has dipped below 20% on 26 separate occasions. So you can't dismiss the findings as anomalies.

And just like today, when bullish sentiment readings are extremely low, the implications for stocks couldn't be more, well… bullish!

  • For 24 out of 26 occurrences, stocks jumped higher three months following a low sentiment reading. That works out to 92.3% of the time. The average gain? 6.5%.
  • And for 25 out of 26 occasions, or 96.2% of the time, stocks shot higher six months following a low sentiment reading. The average gain? An impressive 13.4%.

Such much for the wisdom of crowds, huh?

Bottom line: You're not going to find a more accurate contrarian indicator in the market. When bullish sentiment tanks, forget bailing on stocks. Consider backing up the truck, instead. Or as Bespoke Investment Group wrote in a note to clients, "The historical evidence suggests that investors who turned bearish may want to change course." True that!