Sentiment Supports the Borrowing of 2017 Gains Argument
Thursday, December 1, 2016

Support for the concept of the post-election ("Trump") rally borrowing gains from 2017 can be found in our Sentiment Survey. Optimism was both unusually low (a bullish sign) and unusually high (a bearish sign) in recent weeks. Though seemingly contradictory, the two signals may not be when the post-election rally is taken into account.

I’ll start with the very large jump in optimism that occurred last month. Bullish sentiment surged by 26.3 percentage points between November 2 and November 23. This was the 13th biggest three-week increase in the survey’s 29-year history. It was also the largest three-week increase since 2010. (Bullish sentiment rose by 30.2 percentage points from August 26 to September 16, 2010. For those of you who are curious, the largest three-week increases were 40-point moves in August 1987 and July 2000.)

The most obvious question is: What does the move say about market direction? The average six-month gain for the S&P 500 following the 12 bigger upward moves in bullish sentiment was 0.3%. The large-cap index rose six times and fell six times during those periods. In comparison, the S&P 500 has realized an average six-month gain of 4.3% throughout our survey’s history.

Should the S&P 500 underperform over the next six months, it would reinforce the contrarian nature of unusually high bullish sentiment readings. Whenever optimism has exceeded its typical range, the S&P 500 has realized an average six-month return of 2.7%. Last week’s bullish sentiment reading of 49.9% was above the typical range of 28.0% to 48.7%. (Statistically, we define unusually high readings as being more than one standard deviation above average, and low readings as being more than one standard deviation below average.)

Underperformance is not the same thing as a loss. The S&P 500 has gone on to realize a six-month gain following nearly three out of four of all unusually high bullish sentiment readings. The 27.5% chance of a loss is close to the 26.1% for all six-month periods throughout the survey’s history. So, if history repeats, returns will be lower, but positive. Keep the phrase “if history repeats” in mind when thinking about that last statement. The future can unfold in ways we don’t we expect it to.

If we were to go back to the start of November, a different contrarian signal was being flashed: Bullish sentiment was at 23.6% on November 2, 2016. On average, the S&P 500 has realized a 7.2% six-month gain following an unusually low bullish sentiment reading. Currently, as stated above, any reading below 28.0% is unusually low. We’ve seen optimism come in at unusually low levels many times this year—23 different weeks, to be exact.

The contradictory signals could be reconciled if one were to believe the post-election rally is borrowing from next year’s gains. Between the election and November 23 (the end of last week’s survey period), the S&P 500 rose by 3.0%. Add in an additional 2.7% gain following unusually high readings (such as what occurred last week) and the cumulative return would be both above average for the six-month period starting on November 2 and below average for the six-month period starting on November 23.

This is an explanation based on historical data. It demonstrates how two contrarian signals can both be valid even though they seem contradictory at first glance. It is not a forecast of what will happen even though it lends support to the concept of Mr. Market having borrowed from his 2017 gains. Unusually low or high bullish sentiment readings do not cause stocks to outperform or underperform. Furthermore, the new administration, monetary policy, economic growth, corporate earnings and valuations will all influence sentiment (both individual and institutional) and the direction of stock prices. The S&P 500’s return over the next six months could very well be different than what our survey’s historical data suggests.

For those of you who are interested, the table below contains an updated analysis of the AAII Sentiment Survey. The numbers are calculated without hindsight. Rather, I used the historical data that would have been available on a given week in the past to determine whether bullish, neutral or bearish sentiment was unusually high or low.

When crunching the numbers, I observed a shift in how unusually high levels of neutral sentiment should be viewed. It’s no longer a clear contrarian signal. The S&P 500 has gained 4.3% following unusually high levels of neutral sentiment. This is down from the 7.2% average gain calculated in May 2015. The difference is due to a larger sample size: 111 unusually high readings now versus 71 in 2015. The sample size is still comparatively small relative to the data we have for bullish and bearish sentiment, however.

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 2.7% 4.3% 4.5% 2.6% 4.9% 3.5% 4.3%
Median 3.8% 4.7% 5.8% 3.0% 6.6% 3.9% 4.9%
Periods with Gains 214 80 196 219 244 187 1095
Periods with Losses 81 31 99 94 116 66 403
Total Count 295 111 295 313 360 253 1498
Percent Contrarian 27.5% 72.1% 66.4% 30.0% 67.8% 26.1%  
Contrarian Movement Losses Gains Gains Losses Gains Losses  
-1 Standard Deviation above Average, 26-week Returns
Average 7.2% 2.1% 3.8% 7.0% 4.0% 5.4% 4.3%
Median 6.3% 3.1% 4.4% 6.3% 4.5% 6.2% 4.9%
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%  
Contrarian Movement Gains Losses Losses Gains Losses Gains  
+1 Standard Deviation above Average, 52-week Returns
Average 5.7% 11.1% 7.5% 5.7% 8.3% 6.8% 8.9%
Median 7.7% 10.6% 12.1% 7.7% 12.4% 8.4% 10.4%
Periods with Gains 216 73 207 233 256 192 1159
Periods with Losses 79 23 85 80 100 61 313
Total Count 295 96 292 313 356 253 1472
Percent Contrarian 26.8% 76.0% 70.9% 25.6% 71.9% 24.1%  
Contrarian Movement Losses Gains Gains Losses Gains Losses  
-1 Standard Deviation above Average, 52-week Returns
Average 12.6% 2.9% 7.5% 12.5% 10.6% 8.6% 8.9%
Median 15.4% 7.1% 9.0% 13.0% 11.9% 14.2% 10.4%
Periods with Gains 122 243 130 125 145 167 1159
Periods with Losses 27 142 43 18 35 56 313
Total Count 149 385 173 143 180 223 1472
Percent Contrarian 81.9% 36.9% 24.9% 87.4% 19.4% 74.9%  
Contrarian Movement Gains Losses Losses Gains Losses Gains  
Source: AAII Sentiment Survey; Data from June 24, 1987 through November 23, 2016

 

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Highlights from this month's AAII Journal

The Week Ahead

We are currently in the lull between third-quarter and fourth-quarter earnings season. Still, six members of the S&P 500 will release results next week: AutoZone (AZO) on Tuesday; Brown-Forman Corp. (BF.B), Costco Wholesale Corp. (COST) and H&R Block (HRB) on Wednesday; and Broadcom (AVGO) and Cooper Companies (COO) on Thursday.

The week’s first economic reports will be the November ISM non-manufacturing survey, which will be released on Monday. Tuesday will feature October international trade, October factory orders and revised third-quarter productivity. The Labor Department’s October Job Openings and Labor Turnover Survey (JOLTS) will be released on Wednesday. Friday will feature the University of Michigan’s initial December consumer sentiment survey.

Three Federal Reserve officials will make public appearances on Monday: New York president William Dudley, Chicago president Charles Evans and St. Louis president James Bullard.

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AAII Sentiment Survey

Optimism pulled back in the latest AAII Sentiment Survey after having risen significantly over the previous three weeks. Both neutral and bearish sentiment rebounded this week, after having both previously fallen.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell by 6.1 percentage points to 43.8%. The pullback follows last week’s reading of 49.9%, which was the highest level recorded by our survey since January 1, 2015 (51.7%). Even with this week’s drop, bullish sentiment remains above its historical average of 38.5% for a fourth consecutive week.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 3.1 percentage points to 31.1%. The increase puts neutral sentiment about even with its historical average of 31.0%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 3.0 percentage points to 25.1%. Pessimism was last lower on August 17, 2016. The increase is not large enough to prevent pessimism from remaining below its historical average of 30.5% for a fourth consecutive week.

This week’s results follow a significant shift in sentiment. During the three-week period of November 2 through November 23, 2016, optimism rose by a cumulative 26.3 percentage points, neutral sentiment fell by a cumulative 14.0 percentage points and pessimism fell by a cumulative 12.2 percentage points. The rise in bullish sentiment was the 13th largest three-week increase in the survey’s 29-year history.

The election’s outcome remains front and center for many AAII members. Some are encouraged by possible changes President-elect Donald Trump could make, while others are uncertain or want to wait to see how his administration’s policies and their impact on the market evolve. There are also individual investors who are pessimistic following the election. Beyond the election, the direction of interest rates, the pace of economic and earnings growth, and valuations are influencing individual investors’ expectations for the stock market.

Last week’s special question asked AAII members how third-quarter earnings have impacted their market outlook. Responses were very mixed. The largest group of respondents (28%) said that third-quarter earnings did not have any impact or had little impact on their market outlook. Many of these respondents said the election’s outcome was more influential. About 18% described themselves as being more optimistic due to earnings, particularly over the short term. Conversely, 11% said that earnings remain too low to support current valuations. Others said that they are anticipating more/continued market volatility or want to see how the market reacts to the new administration over the coming months.

Here is a sampling of the responses:

  • "Earnings, not very much. Politics, on the other hand, are having a MAJOR effect.”
  • "Earnings were satisfactory, but the market P/E is still high, suggesting trouble ahead.”
  • "Quarterly earnings data is mostly just noise—to be ignored.”
  • "Earnings have improved my outlook for stocks.”
  • "Generally modest earnings translate into modest growth in the market.”

This week’s special question asked AAII members how the average consumer is fairing relative to a year ago. Approximately 45% view the average consumer as faring better or somewhat better than a year ago. A better job market, low inflation and economic growth were the primary reasons why. Slightly more than 20% think the average consumer is faring about the same as a year ago. Some of these respondents cited a lack of adequate wage growth. Nearly 15% think the average consumer is faring worse, primarily because of a perception that wage growth is not keeping up with inflation.

Here is a sampling of the responses:

  • "About the same. Gasoline prices remain low, but food seems to keep getting more expensive.”
  • "Better. Employment is higher, interest rates remain low and inflation is still in check.”
  • "Better. Job growth has been steady, wages are up and inflation is low.”
  • "Fair to poor because income is not keeping up with real inflation.”
  • "I believe the average person is doing better, but not significantly better.”


This week’s Sentiment Survey results:

Bullish: 43.8%, down 6.1 points
Neutral: 31.1%, up 3.1 points
Bearish: 25.1%, up 3.0 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

AAII Asset Allocation Survey

Individual investors have reduced their cash holdings, on a percentage basis, to the smallest amount since the spring of 2015, according to the November AAII Asset Allocation Survey. Fixed-income allocations declined as well. Conversely, equity allocations rose to their second-highest level of the year.

Stock and stock fund allocations rose 1.7 percentage points to 66.4%. This is the largest allocation to equities since August 2016 (66.6%) and the second largest since July 2015 (67.4%). The increase kept equity allocations above their historical average of 60.5% for the 44th consecutive month.

Bond and bond fund allocations declined 0.2 percentage points to 16.4%. November was the 16th consecutive month that fixed-income allocations were above their historical average of 16.0%.

Cash allocations fell 1.5 percentage points to 17.2%. On a percentage basis, cash holdings were last lower in May 2015 (16.2%). (Cash allocations were also 17.2% in July 2015.) Last month’s drop keeps cash allocations below their historical average of 23.5% for the 60th consecutive month.

Last month’s results reflect a shift in short-term trends, as individual investors had been increasing their fixed-income and cash holdings during the two months preceding the election. The rise in equity allocations occurred as optimism about the six-month direction of the stock market among AAII members rose significantly last month, according to our weekly sentiment survey.

Some individual investors are encouraged about the potential changes president-elect Donald Trump’s administration could make. Others are waiting to see what the impact of his presidency will be, and some are concerned. At the same time, prevailing valuations, frustration with still low interest rates, monetary policy and a perceived lack of alternatives to stocks are also influencing individual investors’ allocation decisions.

Last month’s special question asked AAII members whether changes in bond yields or the Federal Reserve’s target for interest rates have a bigger impact on their allocation decisions. Just under half of all respondents (49%) said neither changes in bond yields nor the Fed’s interest rate target drives their asset allocation decisions. Many of these individual investors said they are focused on the long term, don’t own any or only have a small allocation to bonds, or believe any forthcoming rate hike will be too small to have a lasting impact. An additional 11% said that they adhere to a long-term allocation strategy instead of responding to short-term events. About 12% said that changes in monetary policy have a bigger impact. Another 11% of respondents said that both monetary policy and changes in bond yields influence their allocation decisions.

Here is a sampling of the responses:

  • “A quarter of a one percent increase should ultimately have little effect.”
  • “Not yet. Rates will need to go much higher.”
  • “No. If bond yields go up, I would still only have a small allocation to bonds.”
  • “Don’t like bonds here at all. Don’t own any and won’t get any.”
  • “I will not change my allocation because I am a long-term investor and seldom change my allocations.”
  • “Changes in bond yields have a larger impact than Federal Reserve targets because they have a direct impact on my returns.”
November AAII Asset Allocation Survey results:
  • Stocks and stock funds: 66.4%, up 1.7 percentage points
  • Bonds and bond funds: 16.4%, down 0.2 percentage points
  • Cash: 17.2%, down 1.5 percentage points

November AAII Asset Allocation Details:
  • Stock funds: 35.2%, up 0.9 percentage points
  • Stocks: 31.1%, up 0.7 percentage points
  • Bond funds: 13.4%, up 0.5 percentage points
  • Bonds: 3.0%, down 0.7 percentage points

Take the Asset Allocation Survey.


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