Portfolio Allocations Often Do Not Follow Shifts in Sentiment

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Bullish sentiment in our AAII Sentiment Survey fell this week to its lowest level since July 2020. Bearish sentiment, meanwhile, rose to its highest level since September 20. Bullish sentiment measures the percentage of individual investors that expect stock prices to rise over the next six months. Bearish measures the percentage of individual investors that expect stock prices to fall over the next six months. Optimism is at 21.0% and pessimism is at 46.7%. The timing of these unusually low and unusually high readings is apropos as I wrote most of this week’s commentary yesterday before the latest survey results were tabulated.

We at AAII have long observed that individual investors’ short-term outlook for the stock market and how they allocate their portfolios frequently do not go hand in hand. While there are periods when sentiment does influence allocation decisions—particularly during severe downturns—AAII members frequently make fewer portfolio moves than the weekly fluctuations in our Sentiment Survey would suggest. 

Last year was a good example: Average equity allocations were at their fourth-highest level on record. The average combined allocation to stocks and stock funds recorded by our AAII Asset Allocation Survey was 70.5% in 2021. Only 1999 (72.4%), 1998 (71.5%) and 2000 (71.1%) saw greater exposure to equities. This monthly survey was started in November 1987.

The average percentage of individual investors expecting stock prices to rise over the next six months (“bullish”) was closer to the middle. Bullish sentiment averaged 39.7% in 2021. This ranked 15 out of the 35 annual average readings we have. The weekly AAII Sentiment Survey started in July 1987. (We include the second half of 1987 in our calculations of average calendar-year sentiment.)

Readings of sentiment from other sources painted a mixed picture of how institutional, professional and individual investors felt last year:

• Investor’s Intelligence survey of newsletter writers showed a historically high level of bulls relative to bears, based on data compiled by Yardeni Research.
• The Investment Company Institute’s data on mutual fund flows showed individual investors pulling $364 billion out of stock mutual funds and putting $397 billion into bond mutual funds.
• Margin debt ended 2021 up nearly 17% from where it was at the end of December 2020. Scale matters here though. Barron’s noted that October 2021’s margin debt high of $936 million equated to 2.4% of the S&P 500 index’s then market capitalization. The high was 3.5% of the S&P 500’s market cap, reached around the time of the financial crisis in 2008 and 2009.
• The CBOE’s equity put/call ratio ended 2021 at 0.55, signaling more traders were seeking gains than protection against drops. Charts of the ratio show lower high values (indicative of less pessimism) than in previous years.

Our historical analysis of the AAII Sentiment Survey shows that unusually low levels of optimism are a key measure for contrarian investors to keep an eye out for. Since July 1987, when the level of bullishness in our survey was more than one standard deviation below its historical average, the S&P 500 has realized six-month average and median gains of 8.2% and 8.0%, respectively. These returns compare to the respective historical average and median S&P 500 returns of 4.9% and 5.5% for all six-month periods since the survey was started. The S&P 500 has risen 82% of the time following an unusually low bullish sentiment reading versus 75% for all six-month periods.

The relationship holds at 12-month periods as well. Following unusually low bullish sentiment readings, the S&P 500 has risen by an average of 14.8% and by a median of 16.4%. For all 12-month periods, the S&P 500 rose by an average of 10.0% and a median of 11.4%.

Currently, bullish sentiment readings below 28.0% are considered unusually low.

When bullish sentiment falls below this level, we suggest stopping to consider the broader market and economic mosaic. Ask what is occurring that would give individual investors reason to feel unusually cautious. The answer may reveal whether it makes sense to check your allocation to see if it is still approximately in line with your goals, if any presently held investments are meeting your sell rules or if it is time to see if there are investments that have been put on sale because of prevailing market conditions.

We do not view unusually low bullish sentiment as a “buy” signal nor do we view unusually high bullish sentiment as a “sell” signal. Sentiment does not have a causal impact on future market performance. It can, however, alert you to consider whether other market indicators are lining up in the same direction.