Extreme Bearishness a Definite Bullish Sign

Includes: DIA, IVV, SPY
by: William Trent, CFA

The American Association of Individual Investors [AAII] released its latest investor sentiment poll:

This week’s survey saw bullish sentiment fall to 42.22%, above its long-term average of 39.3%. Neutral sentiment fell to 12.22%, below the long-term average of 32.1%. And bearish sentiment rose to 45.56%, above the long-term average of 28.6%.

With both bullish and bearish sentiment above the long-term average it seems investors feel strongly one way or the other. However, the negative sentiment seems particularly strong relative to the historical average. With negative sentiment well above the long term average, is the bad news already priced in?

I did a scatter chart comparing the difference between bullish and bearish sentiment (percent bulls minus percent bears) and the subsequent 12-week stock market returns.

click to enlarge

It looks pretty random to me. Possibly a modest inverse relationship (more bearish sentiment is a more bullish indicator than more bullish sentiment) but nothing to justify making a big bet based on the current -3.34 reading.

Looking at the data more closely, there may be a little more to go on. For example, when there are more bears than bulls the average return over the next 12 weeks is 3.7%. When there are more bulls the average is just 1.4%.

Going to more extreme readings, bullish readings above 10% (10% more bulls than bears) average just 1.2% returns, while bearish readings above10% result in an average return of 3.9%.

Having 20% more bulls than bears generates an average return of just 0.7%, while 20% more bears than bulls returns an average of 4.7%.

The top 25 bullish readings were in excess of 47% more bulls than bears and resulted in negative returns over the next 12 weeks on average. -2.4% to be exact. Meanwhile, the 25 most extreme bear readings (minimum 26% more bears than bulls) resulted in an average 4.9% gain over the next 12 weeks.

In summary, it doesn’t seem like bullish readings begin to have much contrary information until they become extreme. The more extreme the bullish reading, the more information it seems to convey. Meanwhile, any bearish reading tends to be a reasonably bullish indicator. And while more extreme bearish calls do result in higher average returns, the incremental returns aren’t as dramatic as for more bullish sentiment.

So, given that the average return when there are more bears than bulls is well above the average return in all markets, I consider the current bearish reading to be a bullish sign for the stock market today.