Are You Convicted?


These days, bulls like to argue that investor sentiment hasn't reached the level of ebullience usually associated with market tops. Markets don't peak when investors lack conviction and easily back away from from their investment postures, so say the bulls.

However, while we can easily measure the percentage of investors who consider themselves bulls or bears, assessing the strength of investors' convictions is like nailing Jell-O to a wall.

Today we attempt to calibrate current sentiment — and the strength of that conviction — among individual investors based on two indicators. 

Odd-lot short selling. A short sale occurs when an investor borrows stock from a broker, then sells it, hoping to profit by buying it back later at a lower price. A high level of short interest usually coincides with pessimistic investor sentiment, given that short sellers bet on declines. 

The short interest ratio on the New York Stock Exchange (calculated by dividing short interest by average daily trading volume) sits just below its five-year high posted in September. Based on trends in odd-lot short selling, individual pessimism seems higher than average.

Odd-lot short selling involves transactions of fewer than 100 shares, trades typically connected to individual investors. Odd-lot short selling is just off its highest levels in two years, suggesting individuals are far from rampantly bullish.

Sentiment surveys. Surveys of individual investors can paint a picture of sentiment at a point in time. But we can also use the volatility of these readings to gauge the strength of that sentiment.

For example: The American Association of Individual Investors (AAII) sentiment survey shows 49% bulls, 18% bears, and 33% neutral. But how much conviction do those bulls feel? The chart above tracks changes in AAII bullish sentiment following movements of the S&P 500 Index.

Since 1987, bullish sentiment has averaged a weekly decline of more than 1 percentage point (1.2%) following a weekly decline in the S&P 500. Since the beginning of this year, the average weekly decline in bullish sentiment following a down week for the S&P 500 has jumped to 1.7%.

Surprisingly, the accelerated changes in bullishness relative to historical norms have occurred during a year when the average weekly decline is smaller than usual.

Bottom line: Based on current data, we hesitate to label individual investors either extremely bullish or bearish. A heightened sensitivity to short-term market moves seems to reflect an increasingly skittish investor populace. We suspect the memory of the market decline in 2008 and 2009 continues to influence to investor nervousness. As long as investors anchor on 2008, we're less likely to see the type of aggressive bullishness consistent with market tops.

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