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May 23, 2015

The Link Between Market Sentiment and Return

Last year, I conducted an updated analysis of our weekly Sentiment Survey to determine if the contrarian link between sentiment and market direction still existed if an investor only used the data available at a given point of time. In other words, I wanted to see what the results looked like if the analysis was done without any hindsight.
As I suspected, stocks tended to do well when bullish sentiment (expectations that stock prices will rise over the next months) was at an unusually low level. This is often happens when there are macro issues creating loss aversion, and thus we see more sellers than buyers. Eventually, valuations become cheap enough to warrant risk taking, and stocks rebound. So, seeing low optimism generally followed by upward rising stock prices was not surprising.
(An exception to the poor market condition scenario occurred last week when bullish sentiment fell to an unusually low level a day before the S&P 500 index closed at a new record high. Many AAII members have expressed some level of concern about the current level of stock valuations, however.)
What was surprising was the link between neutral sentiment and market performance. We define neutral sentiment as expecting the direction of stock prices to be unchanged over the next six months when asking the weekly Sentiment Survey question “I feel that the direction of the stock market over the next six months will be:.” I suspect some AAII members select neutral when they are unsure about market direction, or otherwise do not feel particularly optimistic or pessimistic.
Whatever the exact reason each participating member selects “neutral” on a given week, I found that unusually high neutral sentiment has historically been followed by periods of above-average and above-median returns. The S&P 500 has outperformed over the following six- and 12-month periods when neutral sentiment reached an unusually high level more than 80% of the time.
Since my analysis was completed last May and published in the June 2014 AAII Journal, two events occurred. First, neutral sentiment kept staying above average. It eventually stayed above its then historical average of 30.5% for 32 consecutive weeks between January 9 and August 14, 2014—the third-longest such streak since our survey started in 1987. Second, neutral sentiment started reaching unusually high levels. The latter event was even more notable because between January 2000 and December 2013, neutral sentiment rose to an unusually high level nine times. Between January 2014 and now, neutral sentiment has been at an unusually high level 20 times. This is the largest cluster of weeks with unusually high neutral sentiment during a period of two calendar years since 1987 and 1988, which were the first two years of the survey’s existence.
Given this, I updated the analysis through May 7, 2015; the results are shown below. The updated analysis continues to show a correlation between unusually high neutral sentiment and better-than-average and better-than-median S&P 500 gains.
The data comes with a big caveat, however: sentiment survey readings are not a driver of stock returns. Though there is a link, stocks do not move because sentiment is optimistic, neutral or pessimistic. Rather, sentiment is simply a measurement of current attitudes (in this case, of individual investors). So, while the numbers are interesting and even perhaps encouraging, I would still consider a variety of indicators—particularly your long-term goals and needs—before making any portfolio decisions based on the updated data.
Table 1. Performance of the AAII Sentiment Survey Without Hindsight
Bullish
Neutral
Bearish
Bull 8-wk
Bear 8-Wk
B/B Spread
S&P 500
+1 Standard Deviation above Average, 26-week Returns
Average
2.8%
7.1%
4.4%
2.5%
4.8%
3.5%
4.5%
Median
3.8%
7.7%
5.6%
3.0%
6.5%
4.4%
5.3%
Periods with Gains
210
61
193
212
240
183
1045
Periods with Losses
81
10
98
94
116
65
372
Total Count
291
71
291
306
356
248
1417
Percent Contrarian
27.8%
85.9%
66.3%
30.7%
67.4%
26.2%
-1 Standard Deviation above Average, 26-week Returns
Average
8.3%
2.1%
4.0%
8.4%
4.0%
5.3%
4.5%
Median
7.1%
3.1%
4.5%
7.3%
5.2%
6.1%
5.3%
Periods with Gains
114
240
122
105
126
157
1045
Periods with Losses
21
145
44
19
50
62
372
Total Count
135
385
166
124
176
219
1417
Percent Contrarian
84.4%
37.7%
26.5%
84.7%
28.4%
71.7%
+1 Standard Deviation above Average, 52-week Returns
Average
5.8%
15.5%
7.5%
5.8%
8.3%
7.1%
9.3%
Median
7.9%
15.1%
11.9%
7.9%
12.4%
8.7%
11.2%
Periods with Gains
209
52
205
227
256
182
1058
Periods with Losses
77
7
85
79
100
58
281
Total Count
286
59
290
306
356
240
1339
Percent Contrarian
26.9%
88.1%
70.7%
25.8%
71.9%
24.2%
-1 Standard Deviation above Average, 52-week Returns
Average
13.8%
2.9%
8.1%
13.9%
10.8%
8.7%
9.3%
Median
17.0%
7.1%
10.0%
17.6%
11.9%
14.1%
11.2%
Periods with Gains
112
243
124
111
142
163
1058
Periods with Losses
19
142
37
12
34
55
281
Total Count
131
385
161
123
176
218
1339
Percent Contrarian
85.5%
36.9%
23.0%
90.2%
19.3%
74.8%
Source: AAII Sentiment Survey; Table 1 data from June 24, 1987 through May 7, 2015.









































































The Week Ahead

The U.S. financial markets will be closed on Monday, in observance of Memorial Day.

Just seven members of the S&P 500 will report their quarterly results as first-quarter earnings season nears its end. Those companies are AutoZone (AZO) on Tuesday; Costco Wholesale Corp. (COST), Michael Kors Holdings (KORS) and Tiffany (TIF) on Wednesday; and Avago Technologies (AVGO) and GameStop Corp. (GME) on Thursday.

Four notable economic reports will be released on Tuesday: April durable goods orders, the March Case-Shiller Home Price Index, April new home sales and the Conference Board’s May consumer confidence index. April pending home sales will be released on Thursday. Friday will feature the first revision to first-quarter GDP, the University of Michigan’s final May consumer sentiment survey and the May Chicago PMI.

Three Federal Reserve officials are scheduled to make public appearances: Richmond president Jeffrey Lacker on Tuesday and both San Francisco president John Williams and Minneapolis president Narayana Kocherlakota on Thursday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $35 billion of five-year notes and $13 billion of floating two-year notes on Wednesday and $29 billion of seven-year notes on Thursday.

About The Author - Charles Rotblut, CFA is  the VP and Editor for American Association of Individual Investors (AAII).  Charles is also the author of Better Good than Lucky.  (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle
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