Why Some Swings in Market Sentiment Matter More Than Others

I like to describe market sentiment as a pendulum. Sentiment swings back and forth between being optimistic, neutral and pessimistic. The sentiment pendulum swings within a typical range two-thirds of the time. Such swings are interesting to watch, but are simply normal fluctuations.

On occasion, sentiment shifts enough to pull the pendulum further in one direction or the other. This often happens when other indicators of the market mood also start signaling high levels of fear or greed. Such occurrences are worth paying attention to because the pendulum will swing back in the opposite direction—often quickly.

We have seen this occur time and time again with the AAII Investor Sentiment Survey (and other measures of sentiment). When pessimism dominates the survey’s results, sellers have likely exhausted themselves, setting the stage for rebounds. Conversely, extreme optimism often precedes pullbacks in the S&P 500 index as the pool of buyers shrinks significantly.

Our past analysis of the AAII Investor Sentiment Survey results found that the S&P 500 outperforms (underperforms) whenever a bullish sentiment reading ranks in bottom (top) 16% of all readings. An opposite relationship exists with high and low bearish sentiment (stocks outperform and underperform, respectively). Such benchmarks work well as a rule, but my colleague Wayne Thorp found that using a percentile ranking system works even better as a sign to keep an eye out for a market turnaround.

The new AAII Contrarian Sentiment Indicator ranks our current investor sentiment against historical levels to identify directional bias (bullish versus bearish sentiment) and measure the proportion of bullish, bearish and neutral opinions. It uses a rolling percentile ranking system to adjust to changing market regimes.

AAII Contrarian Sentiment Indicator: Neither Too Hot Nor Too Cold

Source: AAII Sentiment Investing. Data of 7/16/2025.

The adjustments made by the rolling ranking system are necessary because both the averages and the border separating typical and unusual readings shift over time.

Using a rolling percentile ranking system also acknowledges that structural shifts can take place in investor sentiment. For example, from 1987 through 2010, bullish sentiment above 50.0% accounted for 16.5% of all weekly readings. Since 2010, that has dropped to less than 5.0%. Using static thresholds would miss that potential structural shift. What was considered only moderately bullish 10 or 15 years ago may be extremely bullish today if a true structural shift has taken place in investor sentiment.

As I pointed out last week, objectively identifying the current level of investor sentiment helps you determine the market’s mood and when to keep an eye out for a market turnaround. Combining investor sentiment with additional indicators to form a broader mosaic allows you to spot opportunities to pick up stocks at bargain prices, take profits in stocks trading at high valuations, rebalance your portfolio or make a Roth individual retirement account (IRA) rollover at an opportune time.

Our new AAII Contrarian Sentiment Indicator allows you to quickly identify the current level of investor sentiment.

To celebrate the launch of AAII Sentiment Investing, we’re offering an exclusive limited-time discount for AAII members—now just $97 for one-year access (a $199 value). This powerful new platform features not only the AAII Contrarian Sentiment Indicator but over 10 other indicators. Presented on an easy-to-use dashboard, they measure investor and market sentiment as well as market breadth, volatility, trends and valuation.

As you just read, not all sentiment swings are created equal. When sentiment moves beyond its normal range, history shows that a sharp market reversal often follows. AAII Sentiment Investing helps answer one of the most important questions any investor can ask: Where is the crowd positioned emotionally, and what does that mean for forward-looking risk and opportunity?

Be among the first to use our new data-driven Sentiment Dashboard.

Sign up now for just $97 ($199)