Something's Gotta Give

9/11/2017


Every couple months we prepare a Sentiment Snapshot, digging into sentiment data in an effort to determine what investors are thinking and potentially draw some conclusions about the market.

With such conclusions in mind, here are two scenarios:

1) Nearly 50% of newsletter editors are bullish, slightly above the long-run average of 46.4% bullishness. Over the last 28-plus years, after weeks when bullishness has ranged from 45% to 50%, the S&P 500 Index responded with an average price change of 3.9% during the following six months, slightly below the average return of 4.2% for all six-month periods. These numbers suggest bullish sentiment isn't far from typical levels, which puts the market's risk/reward profile firmly inside "business-as-usual" territory.

2) Just 25% of individual investors are bullish, well below the long-term average of 38.5%. Bullishness has fallen this low in just 8% of weekly readings over the last decade. Since 1989, the S&P 500 has averaged six-month returns of 8.4% after periods when bullishness was just 25% or lower, double the index's overall average gain. Recent weakness in the market has combined with fears of high stock valuations to crimp optimism. Historically, such periods of investor nervousness have tended to presage above-average market returns.

The scenarios above paint drastically different pictures of the stock market.

Scenario 1, with its message of fairly typical sentiment levels, draws from Investors Intelligence data about the stance of investment newsletters. Investment professionals don't seem spooked about the ongoing military stand-off with North Korea, the economic impact of Hurricane Harvey, or rumblings of dissatisfaction with President Trump in Washington.

Scenario 2, which reflects a sharp decrease in bullishness over the last two weeks, comes from the American Association of Individual Investors survey. More than half of the investors surveyed cited politics as a factor in their opinion about the stock market's direction over the next six months. Survey respondents also cited concerns about valuation and the potential for rising interest rates.

The disparity between the bullishness of professional and individual investors shouldn't surprise us, given that earnings season is nearly over and news about natural or political disasters now dominates the headlines. History suggests events such as tropical storms and political power struggles tend to have only a minor impact on stock prices in the medium and long term, though individual investors tend to overreact to them in the near term.

Sentiment for individual investors is more volatile than newsletter sentiment, with quicker and sharper changes of direction. While market experts may question (with some validity) the justification for individual investors' shifting opinions, extremes in optimism tend to be bearish for stocks. And extremes in pessimism tend to be bullish.

Check out the table below. Lower levels of bullishness tend to precede higher returns; the trend is both cleaner and sharper with individual investors. Both sentiment metrics have predictive power, and they often point in similar directions. The type of divergence we see today is unusual.

A CONTRARIAN INDICATOR
Stocks tend to perform better after periods of low investor bullishness than they do after periods when confidence runs high. This trend applies to sentiment for both investment professionals and individuals. The data below reflect weekly readings of bullishness since August 1989, a period of more than 28 years, or nearly 1,500 weeks.
--- Individual Investors ---
Investment Newsletters
Bullishness
Number Of
Weekly
Periods
Average Chg.
In S&P 500,
Next 6 Months
(%)
Number Of
Weekly
Periods
Average Chg.
In S&P 500,
Next 6 Months
(%)
Up to 25%
126
8.4
46
5.7
25% to 30%
197
5.5
38
6.5
30% to 35%
247
3.8
79
7.5
35% to 40%
303
4.8
177
5.7
40% to 45%
255
4.4
298
5.9
45% to 50%
177
3.5
357
3.9
50% to 55%
98
1.8
280
1.0
55% to 60%
51
0.8
187
3.9
Over 60%
42
0.5
34
2.3

Since 1989, newsletter bullishness has averaged 8% higher than individual-investor bullishness. However, as of Sept. 6, 49.5% of editors were bullish, versus 25.0% of individuals, for a spread of 24.5%. Such a wide disparity has occurred in just 5% of weekly sentiment readings, and that divergence has not been friendly to investors. After weeks when newsletter bullishness exceeded individual-investor bullishness by at least 24%, the S&P 500 averaged a six-month return of just 1.3%.

Don't misread us — we're not predicting weak market performance any more than we're predicting outperformance. Just keep in mind that during periods when sentiment indicators diverge, it becomes easy to justify both positive and negative arguments. Regardless of which group (individuals or newsletter editors) has historically been more accurate, we'll become more confident in the
predictive power of sentiment when they start to agree again.


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