Unusually High Neutral Sentiment Often Followed by Good Returns
Thursday, May 21, 2015

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.
More on AAII.com

AAII Model Portfolio Update

There are no changes to the Model Shadow Stock Portfolio this month.

Two stocks in the portfolio qualified for purchase at the end of April: SigmaTron International (SGMA) and Universal Stainless & Alloy (USAP). Qualified stocks are companies held within the Model Shadow Stock Portfolio that currently meet the purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.) 

Kimball International, Inc. (KBAL) is currently above the Model Shadow Stock Portfolio’s valuation limit, ending April with a price-to-book ratio of 2.70. Stocks are eligible for deletion if their price-to-book ratio exceeds 2.40. Kimball International may be eligible for deletion if its price-to-book ratio is above the limit at the portfolio’s next quarterly review, results of which will be published on AAII.com on June 15. 

Three stocks in the portfolio are on earnings probation because their last 12 months of earnings from continuing operations are negative: Five Star Quality Care (FVE), International Shipholding Corp. (ISH), and Mitcham Industries (MIND). Stocks on probation are potential sell candidates at the next quarterly review. 

There were no changes to the Model Fund Portfolio. The portfolio’s quarterly review will appear in the August issue of the AAII Journal, and any changes will be announced on AAII.com on July 15, 2015. 

The Model Shadow Stock Portfolio’s 0.8% decline for April, coming off of a big March, handily beat both of its comparison benchmarks: The Vanguard Small Cap Index fund (NAESX) lost 1.7% and the DFA US Micro Cap Index fund (DFSCX) lost 2.0% in April. Year to date, the Model Shadow Stock Portfolio has gained 4.7%, while the NAESX is up 3.0% and the DFSCX is up 1.1% over the same time period. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual average return of 16.9%, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.3% annually over the same period. 

The Model Fund Portfolio’s 0.5% increase in April compared to a 0.4% increase for the Vanguard Total Stock Market Index fund. Since its inception in June of 2003, the Model Fund Portfolio has a compound annual average return of 9.3%, slightly trailing the Vanguard Total Stock Market Index fund over the same time period, which gained 9.4%. 

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.

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AAII Sentiment Survey

Neutral sentiment set a new record for the longest stretch above 45%, which has now reached its seventh consecutive week. Optimism set a new two-year low for the third consecutive week in the latest AAII Sentiment Survey.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 1.5 percentage points to 25.2%. This is the lowest amount of optimism recorded by our survey since April 11, 2013 (19.3%). The drop keeps optimism below its historical average of 39% for the 11th week in a row. This streak now ties an 11-week below-average stretch between March 20 and May 29, 2014.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.9 percentage points to 49.8%. The increase keeps neutral sentiment above 45% for the seventh consecutive week and above its historical average of 31.0% for the 20th consecutive week.

Bearish sentiment, expectations that stock prices will fall over the next six months, fell 1.4 percentage points to 25.0%. This is the 17th week this year where pessimism has been below its historical average of 30%.

Neutral sentiment set a new record for consecutive weeks above 45%, beating a 27-year record. Neutral sentiment stayed above 45% on six consecutive weeks between May 13 and June 17, 1988. The new record of seven weeks above 45% spans from April 9 to May 21, 2015.

Bullish sentiment remains at an unusually low level, while neutral sentiment continues to stay at an unusually high level. Historically, such readings—both unusually high low bullish sentiment and unusually high neutral sentiment—have been correlated with better-than-average market performance over the following six- and 12-month periods. (See Analyzing the AAII Sentiment Survey Without Hindsight in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat itself in the future, however.

Causing some AAII members to be cautious or pessimistic are prevailing valuations, recent price volatility, geopolitical events, the pace of economic growth, the impact of the stronger dollar on earnings growth and worries that a notable decline in stock prices could occur. Keeping other AAII members encouraged are the ongoing bull market, sustained economic expansion, earnings growth and still-accommodative monetary policy.

This week’s Sentiment Survey special question asked AAII members if first-quarter earnings have influenced their six-month outlook for stocks. About three of out every 10 respondents (31%) said recent earnings announcements have made them more bearish over the next six months. Nineteen percent described themselves as being bullish over the next six months. Close to 50% of respondents said that first-quarter earnings results have not affected their six-month outlook on the stock market.

Here is a sampling of the responses:

  • “Confirming my opinion, market earnings were not as robust as many analyst had expected.”
  • “A diversified portfolio will go up and down in the short term. I intend to maintain my allocations, and the first quarter reports are irrelevant to me.”
  • “First-quarter earnings are prompting me to take a more cautious outlook on stocks and to think about a larger investment in bond funds.”
  • “I am in it for the long run and try to ignore the daily flack. I believe over the long run stocks should be part of my portfolio.”
  • “Affirmed my moderately bullish outlook.”
  • “Not materially, first-quarter 2015 earnings were pretty much as expected for most companies I follow.”


This week’s Sentiment Survey results:

Bullish: 25.2%, down 1.5 points
Neutral: 49.8%, up 2.9 points
Bearish: 25%, down 1.4 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!