• A widely followed measure of investor sentiment is showing historically low levels of bullishness
  • The survey’s bullish sentiment has dropped below 20% a total of 31 times — and 4 of these drops were in 2016 alone
  • Drops in sentiment have been followed by strong market results — a 12.6% average six-month gain and a 19.6% average 12-month gain for the S&P 500 Index

Gloomy investors may be good news for equities. Each week, the American Association of Individual Investors [AAII] asks its members a simple question: “Will the direction of the stock market over the next six months be up (bullish), flat (neutral), or down (bearish)?” This question is part of the AAII Sentiment Survey. The AAII started polling its 160,000 members in 1987. The typical AAII member is between 60 and 70 years old and holds a bachelor’s or graduate degree. AAII members tend to be affluent, with a median portfolio value in excess of $1 million.

How investor moods correlate with market trends
This survey is a widely followed measure that provides insight into the moods of individual investors. The survey’s long-term results show how investor sentiment tends to break down: Over the life of the survey, bullish sentiment has averaged 38.8%; neutral sentiment has averaged 30.5%; and bearish sentiment has averaged 30.6%.

What is especially interesting and informative in these numbers is that extraordinary readings, defined as those that are nearly two standard deviations away from the historical average, have given hints of future trends in market returns.

Not a lot of love for equities this year

Today, the AAII survey shows an extraordinary low level of bullish optimism. During the survey’s history, bullish sentiment has dropped below 20% a total of 31 times — and 4 of these drops were in 2016 alone. This reading is historically indicative of better returns for the market over the next 6 and 12 months.

Extraordinarily low levels of optimism have proven to be reasonably effective as a contrarian signal. Historically, when we have hit such lows, the S&P 500 Index has responded by rising 26 out of 27 times. The outcomes of this year’s plunges are still to be seen, as we await their 6- and 12-month forward returns.

However, in the 27 preceding instances, the only anomaly to the positive returns was 2008 amid the Great Recession. The S&P 500 Index has risen every other time following a survey that indicated an extraordinarily low level of optimism. In fact, following an extraordinary drop in bullish sentiment, the average 6-month gain for the S&P 500 has been 12.6%. Over 12 months, the average gain has been 19.6%. Note that index return data exclude any management fees, transaction costs, or other expenses investors can incur in actual trading.

A contrarian’s market?
While the AAII Sentiment Survey offers significant insight, it is one of many market indicators that should be considered to give investors a broad context for making investment decisions. It is not prudent to rely on a single indicator when making portfolio decisions. However, this indicator resonates especially strongly for me — a former value portfolio manager closely attuned to contrarian signals.