• Historically, the AAII survey of investor sentiment has offered valuable, often contrarian clues about the stock market.
  • The survey’s bullish sentiment has dropped below 20% a total of 31 times — and four of these declines occurred in 2016 alone.
  • When bullish sentiment reaches extreme lows, it has historically been a positive indicator for equity markets over the next 6 and 12-month periods.

A year ago in the middle of June I wrote about a market sentiment indicator that historically had shown that investor pessimism can be a good sign for the stock market.

How the survey works
The indicator is the survey of the American Association of Individual Investors [AAII], which each week asks its members, “Will the direction of the stock market over the next six months be up (bullish), flat (neutral), or down (bearish)?” While the AAII does not represent professionals, its membership is more engaged with investing than the general public. 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.

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%.

Investor pessimism can have a bright side
In June 2016, the S&P 500 Index was hovering near 2,100, and the AAII survey was decidedly bearish. A year later, however, the S&P has smashed through multiple record levels and risen above the 2,400 level.

Pessimism has, in fact, been a persistent feature of the survey for a long period. It has been 126 straight weeks, dating back to early 2015, since the bulls represented a majority, which is the longest such run on record. Recently, as of the last week of May, bullish sentiment fell to 26.9%, well below the historical average.

How investor sentiment has historically related to market trends
Extraordinarily low levels of optimism have proven to be reasonably effective as a contrarian investment signal. Historically, when the survey has hit lows — when less than 20% of investors are bullish — the S&P 500 Index has responded by rising 30 out of 31 times. (The only anomaly to the positive returns occurred in 2008, amid the Great Recession.)

The gains during these rallies were considerable: 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 excludes any management fees, transaction costs, or other expenses investors can incur in actual trading.

Sentiment has plunged again this year, and we will be watching to see whether the market rises over the coming 6 and 12 months, consistent prior historical patterns.

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.