What the AAII Sentiment Survey is telling us

The American Association of Individual Investors (AAII) performs a “Sentiment Survey” each week. Its members are asked if they are feeling Bullish, Bearish or Neutral about stock market performance over the following six months.

The survey is interesting because it is a well-known contrarian indicator. This means that when a lot of investors are bullish on the survey, meaning they expect stocks to do well, stocks tend to do poorly in following months. Contrarily, when a lot of investors are bearish, meaning they expect stocks to plunge, the stock market tends to do better than average. This behavior holds on average, and the findings are discussed here.

What happens when an unusually large proportion of investors is neutral? A fairly rigorous study found that high neutral sentiment more consistently signals that stocks will do well in the following months than high bearish sentiment. As an aside, the study also found that the sentiment indicator is better at predicting rebounds than in timing crashes.

This week’s survey results are interesting for the following reason. On average, ~40% of investors are bullish, ~30% are bearish, and ~30% are neutral. This week’s readings are 17.8% bullish and 52.9% neutral. Very few investors are bullish this week: 2 standard deviations below the mean. At the same time, too many investors are neutral: 2 standard deviations above its mean. This combination of extremely low bullish sentiment and very high neutral sentiment is extremely rare. It has happened just five times in the past, or just five weeks out of the ~29 years the survey has been in existence. And all of those five weeks happened between May 1988 and March 1989, a period when memories of the rapid collapse of October 1987  (Black Monday) were still fresh in investors’ minds. The AAII has devoted a special blog post to this rare occurrence.In the months that followed this rare combination, the S&P500 did quite well. Are we set up for a repeat performance?

The question above cannot be answered with confidence based on such little data; however, the author of a study I cited above conjectures why it may be that high neutral sentiment and low bullish sentiment precede high stock market returns. I quote:

The data shows that it has been better to buy stocks when investors do not expect good short-term returns than when they expect prices to fall … In other words, Baron Rothschild’s advice of buying “when there is blood in the streets” may not be the best guidance. Rather, the time to buy may be when investors think there is a possibility of blood pouring (or more blood pouring) onto the streets or are simply uncertain about whether Mr. Market will be in a chipper or sullen mood.”

“There may be a logical reason for this. High levels of neutral sentiment suggest that while investors are not optimistic about the short-term outlook for stocks, they are not fearful of owning stocks either. This implies investors are staying engaged versus avoiding stocks. Low levels of bullish sentiment imply investors are not optimistic that prices will rise, while high levels of bearish sentiment imply investors expect stock prices to fall. The seemingly subtle difference is tied to loss aversion—an investor who is worried about falling prices will be less likely to buy stocks than one who merely doesn’t expect prices to rise over the short-term. The latter investor will be more willing to risk temporary lackluster performance if he thinks valuations are attractive enough or may be looking for signs that a market bottom has been established.

One final caveat. The near term movement of stocks is notoriously hard to predict consistently. The rewards of succeeding are so great that an enormous amount of effort and money is directed towards this endeavor. One of the blogs I follow had a post recently which talks about this difficulty using the term science envy. At the same time when the AAII sentiment indicator is suggesting that stocks will do well in the next 6-12 months, there are other indicators that are suggesting the opposite.

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