Investor Sentiment and Market Returns: Now's the Time to Be Bold

Investor sentiment is at its lowest since 1990 and second lowest since the American Association of Individual Investors [AAII] sentiment indicator began in 1987. On 2/7/08, the 8-week moving average bull/bear spread reached the low of -25% and has since hovered below -20%. What does it mean for investors that the bull/bear spread stands at -25%? And what is the bull/bear spread?

Are you bullish, bearish, or neutral?

That’s the question asked by the AAII, which has been conducting weekly market-outlook surveys of its members since 1987.

The bull/bear spread is the bullish percentage of the answers minus the bearish percentage of the answers. For instance, if 30% are bullish, but 50% are bearish, then the bull/bear spread would be 30%-50%=-20%. Since investor sentiment is very votalile, the 8-week moving averaging is used to smooth out the kinks. The AAII has 20 years of data with which we can study the relationship between investor sentiment and stock market return.

Current low investor sentiment is significant because there were only six instances (excluding this one) when it was below -15%. And only two instances when it was below -20%.

How does bearish investor sentiment relate to stock market return?

I used the small sample of six prior occasions when the bull/bear spread was below -15%. I then studied the subsequent one-year returns by the S&P 500 and the Fama/French Small Cap Value Benchmark Portfolio. The result is displayed in the table below.

Time (8 weeks ending on )	8 week MA bull/bear spread	S&P 500 one year return	Small Cap Value one year return
11/2/1990	-37%	25%	46%
2/7/2008 (this time)	-25%	?%	?%
10/23/1992	-21%	12%	40%
3/13/2003	-18%	40%	82%
7/2/1993	-15%	0%	11%
7/20/2006	-15%	23%	23%
3/16/1990	-15%	9%	-2%
Average	-20%	18%	33%

Data sources: AAII, Kenneth French data library

History shows that the worst decline is over once the indicator shows a reading of -15% or below.

One-year returns for the S&P 500 ranged from 0% to 40%, while those for the Fama/French Small Cap Value Benchmark Portfolio ranged from -2% to 82%. To the extent history repeats itself, the current risk/reward outlook of stock investing is heavily skewed toward rewards.

Warren Buffet put it best when he said: “Be greedy when others are fearful.“

Disclosure: Long IWN

Comments

[Lilguy]

No doubt market sentiment is bearish. The question is whether we're at the bottom of the bearishness (and the market), or will we beat the -37% record that now stands. And if so, when?

If you believe, like I do, that the current recession will be moderate, but longer than average, ending maybe in late 2009 or 2010, this would not be the time to jump in the pool.

The water could get even colder in the next few months.

[Semper Gumby]

Bold may turn into early. This recession will be like a saucer but may be a fruit bowl if the housing market doesn't pick up until 2010. Either way consumer resources are diminished without home equity.

[ValueHunter]

Sentiment was very bearish on the Titanic just before it sank.

[sliman]

Sentiment on the Titanic was BULLISH before it sank. Time to buy now or real soon.

[special1person]

There are bold pilots.

There are old pilots.

But there are no old, bold pilots.

[isherlock]

i think the first 3 comments just proved the point of your article, hahaa

[User 169744]

I've used this indicator for years and what you really want to see is a market rally and the number of bulls staying low. That indicates that individual investors have given up. Bulls were down in the low 20s at the January lows but as the market rallied, bulls jumped quickly into the mid 30s. If we get a rally and the number of bulls stays in the 20s, the bottom is probably in.

[medic911]

The problem is, there are certain unprecedented actions and events taking place right now, which render past historical models useless.
This includes but is not limited to the Fed's activities, and also the paradigm shift of strength from the U.S. toward China and other emerging markets.

[jimbomo]

If we were looking at a chart from a physics or chemistry experiment, I might believe this data. However, there are simply too many variables to account for in a global economy. This data may be a piece of the puzzle but it seems illogical to rely on it too much. EOM

[bruin532]

If you listen to knowledgeable economists (not talking head pundants) the fundimental problems we face are unusually challenging. These problems banking, energy, national debt are severe enough to require Goverment actions not seen since the great depression (the markets are no longer self correcting). Looking forward the retiring baby boom generation and exit of wealth to the middle east will put added stess on our monitary system and stock markets. The past eight years of inflation and record deficits have left us I'll prepared to defend this economy. The middle class the economic back bone of the country has been nuetered by the loss of spending power through lost real wages, soaring living costs and record personal debt. It gives me no confidence that this admiistration has a list of failures that have occured on their watch. I'll stay liquid and invest defensively. I'd rather miss 10% upside than incure the possible downside.

[bruin532]

With the shifting of wealth to the middle east. Loss of spending power to the middle class and failure of this administartion to protect this economy my expectations are low. We face a retiring baby boom generation high living/energy costs and non-self correcting markets. Your model goes back to 87 not much of a history. I'll invest defensively if at all and live to invest another day.

[mmmparsley1]

Money is being printed with rapidity to increase "liquidity".

Who's fearful it's going to end up in Joe Sixpack's pocket? Not I.

Who thinks it is going to end locked in commodities sending them to levels that cause commodity prices to fall sharply on their own weight, while destroying economic growth? Not I.

Who think it's going to end up in companies that are innovating and creating new efficiencies (alternative energy, distribution technology) instead of just extracting stuff from the earth? I do.

Stocks are going to rise from here - especially China Stocks.

Buy EFUT, WX, XFML now, and you'll be sitting pretty in 10 years.

[Muzie]

6 samples isn't enough to make any case of statistical inference about future probabilities.

Moreover, with the S&P average return over the last 40 years being about 10%, 3 of your samples were above average, 2 were average and 1 was below average. Not exactly a glaring relationship when you view it that way.

It would take only a single, 7th bad sample at -10% to -15% to even out your limited sampling and bring it down to the S&P yearly average.

In all, your evidence is extremely flimsy.

[daffy]

What is a knowledgeable economist? An arm chair economist that majored in business administration in college? Or a failure at a investment bank after a year? I know oodles of people who have an economics degree and spout off about how this administration is at fault for everything and that the US is going to be flushed down the toilet this year. I also saw millions of homeowners during the boom become seasoned General contractors who could efficiently and effectively run a construction project. Give it a rest and go vote for Obama, obviously he will do a better job with the economy with his infinite wisdom.

[bruin532]

My feeling is the market still havs another leg down before it bottoms. I'm bullish on some china stocks WATG, CAAS betting on the eventual production of low priced small cc autos and YGE a good Solar play all three are industrial with real profits and excellant growth and should hold up well in a sagging economy. The others mentioned in an earlier post are all attractively priced but I'm not fimiliar enough to want to own them.

[Matt Callow]

Great article, and in general, I agree with the relationship of when sentiment dives, it's time to buy. However, your six historical examples are based on when negative sentiment peaked. We don't know when or where it will peak this time around, so I think you are comparing apples to oranges. In the example where negative sentiment peaked at -37%, I wonder how they would have done if they bought when sentiment was at -15%???

Finally, I think the internet delivers info so fast today, that sentiment moves much faster than it ever did before. We can get to that -15% today, much quicker than we did in the early 90's.

[Dr. C.]

Wish you would have included data on 1929 and 1970 - all your data points reflect recent observations in a cyclical bull period. Things could well be different now.

[bruin532]

You article does imply its TIME TO BE BOLD is this the bottom if so make the call to support your position.

[gordon]

Those of you thinking/assuming history repeats itself keep writing this garbage. What you forget is past stock market recoveries were done WITH BORROWED MONEY! As in $1billion++ in home equity withdrawls spent into an economy showing as business profits. And just where is that going to be replaced now? Americans are cutting 401K contributions and borrowing at record levels from them. Sovergn Wealth funds aren't interested because a stock has to rise double the loss in the dollar's value. Good luck on thinking the past repeats itself.

[Tony Soprano]

Flash Gordon (gordon) wants to conquer the universe with his negative sentiment.

America is too young to die. Someday “yes” but not now! Not this decade nor the next.

America is the best place in the universe to invest.

Good article Michael Zhuang and thanks for your hard work

[mkreisel]

Geez! So many bearish flamers!

[gordon]

Just giving the facts,but I was wrong. HOME EQUITY WITHDRAWLS IN 2007 was $250 BILLION. Here are the facts, in detail, if you don't think it's important in comparison to consumer spending, keep loading up on stocks. The gravy-train is almost over, read it.
www.financialsense.com/Market/wrapup.htm

[KRANKY]

The unwinding of leverage and exposure of illiquidity still has a long way to go.
What we are in now is not your typical cyclical bear. So many businesses have engaged in Enron accounting, and this has to play out.
We might have had a capitulation crash that would have made reality clear, but, due to the trading stops put into effect after '87, that is unlikely to happen.
This means that the LL/LH rollercoaster will be protracted and deeper than projected.
I see S&P500 at 1,130 as the best before this slide is over, with the 50% possibility of 930 if this is the secular bear it is looking more like.
I agree with others here: jumping into the markets full-fledged now would indeed be bold, but I think early.

[degreenodal]

It's a sentiment indicator and this sentiment can remain the same or get more bearish for many months to come while the market continues to flounder. Almost ALL technical indicators are above levels found at major bottoms in the past. Of course, this is only useful information if you want to be bold and prudent at a bottom. I take with a grain of salt advice to get long from an investment advisor, as it's inherently conflicted.

[Tony Soprano]

$250 billion in home equity loans? You act as if it's some big surprise. There is nothing, nothing, nothing new regarding negative sentiment. It's baked into stocks.

However, if crude goes to $150 and/or c, mer or Leh goes under that would be a surprise.

[Gtt]

Sentiment only matters if it is too divergent from the current market environment:
www.hussman.net/wmc/wmc041025.htm

[lex]

I remember people telling me to buy Japanese stocks in mid 1991, 6 months into to the bear market, saying its time to be bold and things have bottomed.

I don't think those guys are around anymore.

[Kage]

Well said lex

[nukldrager]

It's a "Creature Feature". And we saw the creature come up for air a couple of weeks ago. That was interesting. Adjusting to new technology may again be part of the problem. As tool makers we've made tools with capacities that outstrip our own. I have no idea if it's time to be bold or not. I just don't think the creature is suicidal, and that ultimately bodes well for those who are engaged and stay hungry.

[john the bear]

The author fails to consider important differences between the current situation and the relatively mild recessions of the recent past. Not since the great depression has the FED been called on to do so much to prop up the markets. So to compare even a -37% to the current market is simply foolish.

I like the comment about the titanic... just because things are still going alright in the economy for the most part, does not mean that the hole in the bottom of the ship just might cause the ship to sink!

Some may be looking at the Dow Theory Forecast and assume that the recent uptick on transportation stocks justify a positive out look. I may be wrong, but I thought the Dow Theory also included the utilities average.

At present only the Dow transports are above the 200 day moving average. The industrials and utilities are still well below their moving average.

Did you know that only Mexico of the major stock exchange indexes around the globe are above their 200 day moving average? That includes China, India, Brazil, England, Germany, Korea, etc.

The Dow theory was developed at a time when USA was de-coupled, but for many years now our markets are directly tied to the success of all the world markets.

So, in my humble opinion, the rest of the world must be added to the Dow Theory to confirm an uptrend. There is nothing that I can see that supports the notion that we have reached a bottom.

Get real, the bull herd has not even been willing to even admit that we are in a "recession" yet. If we had a rally from here, it can only be considered a bear market rally, since we or only at the initial stage of a major recession.

Lets face it, since Citigroup has lost 150 billion of capitalization since the beginning of 2007 and is no longer the largest bank by assets in the country and have to rely on Bank of America as our top bank. we are really in trouble. Consider that BAC acquired the largest residential mortgage originator. Boy was that dumb. Now they are so poor they can't bail out Citigroup, Lehman or Goldman or anybody else.

So now we are told that both BAC and C are in trouble and will be cutting dividends.

Then add to the mix that even Goldman and Lehman are both on the edge of downgrades by S-P.

So hang on to your hat folks, we are still in a downturn that will not reach bottom until possibly 2010, if we are lucky.

[technocrat]

I'm not comfortable with China or India industries for investment ... India is choking on its growth, and China is headed for a devastating ecological, economic and political meltdown ... I think the "defensive" ideas we need to be thinking about should be centered around what we're going to do when China decides to solve its problems by taking territory away from its neighbors and, ultimately, us.

[galewhitaker]

Michael
"Its different this time". Never before in history has the price of energy (read crude oil) been this expensive relative to the salary of the average worker bee. The high price of crude is shutting down the giant shopping machine that comprisies 70% of our GDP. Do you think the price of crude is going to fall anytime soon. Please read J. H. Kunstler's "The Long Emergency". Kunstler says there are NO alternatives to cheap crude oil. I think the time to be bold is a long way off and at much much lower levels.

[D. Smith]

Thanks Michael...good artical.

Great contrarian indicators...

The environment is excellent for incrimentally building positions,
in stocks you want to own long term.

[Aquater]

A plethora of bearish comments that said nothing new and just rehashed concerns that have been repeated ad nauseum by now. Time to at least getting out of shorts and start building portfolio. Those talking bearish after a large bearish move has already taken place will keep doing it way past a bull ride. They will keep predicting Dow lower even at the bottom.

[The Skeptic]

Michael, or anyone else for that matter: I linked to the site with a search for "investor sentiment prior to the 87 crash." I notice in your article that the aaii indicator began in '87. My concern with using sentiment, as expressed in some comments above, is that it could, in rare instances, set you up for a buy just prior to a crash. What was investor senitiment for Bear Sterns on Friday when the price plummeted to 30? Great Buy that day? What about on October 16 of 1987, a brutal down market that followed three weekds of severe declines. Was this the "best buy" in the history of the indicator, with the exception of October 19th?

[Michael Zhuang]

A point of clarification. "It's time to be bold!" was added by the editor, it was not in my title originally. Those who read my articles know that I do simply research and present the result. If the fact is there, what good is there that I give my opinion.

The article is not meant to cover all economic variables. It is meant to be a snapshot from one specific angle.

Some argued the "this time is different" because of the Fed, China, India, Oil prices, etc. Well, every past financial crisis had its own unprecedented challenge, "every time is different". The only constant is the market recovering from each one of them.