The Stretch of Low Optimism Continues

Last month, optimism and pessimism in our weekly Sentiment Survey reached unusual levels. Bullish sentiment plunged to 20.9% on December 12, 2018, while bearish sentiment jumped to a multi-year high of 50.3% by the end of December. Of the two, unusually low readings for optimism have a stronger record of being a contrarian indicator.

The table displayed below on the web version of this commentary shows the historical performance of the S&P 500 index following the unusual readings for our sentiment measures: bullish, neutral and bearish. As I was updating it, I revisited the annual rankings of average bullish sentiment. Specifically, I looked to see how 2018’s average level of optimism compares to past years.

Last year, bullish sentiment averaged 36.4%. This ranks 2018 as having the 10th lowest level of optimism over the survey’s 31.5-year history. (The survey started in July 1987.) What’s more interesting is the recent trend: 2015, 2016, 2017 and 2018 all rank in the bottom 10 when it comes to average levels of bullish sentiment. Put another way, if we were to split the annual averages into thirds, the last four years would all be placed in the bottom tier in terms of how optimistic AAII members were about the short-term direction of the stock market.

This comparatively lower level of optimism has occurred during a mixed stretch in terms of returns. Double-digit gains were realized in 2016 (12.0% total return for the S&P 500) and in 2017 (21.8%). Dividends kept the total return in positive territory during 2015 (a 1.4% total return). Last year was a tough one, with a loss of 4.4%. Combined, the four-year span realized an annualized return of 7.2%. A below-average gain, but certainly not horrible.

The below-average levels of sentiment fit in with the narrative of the post-financial-crash bull market being unloved. They also highlight the difference between expectations and performance. Five of the 10 years with the lowest average level of bullish sentiment saw double-digit gains for large-cap stocks (1988, 1989, 1993, 2016 and 2017). The S&P 500 was barely positive in 1994 and 2015. It incurred losses in 1990, 2008 and 2018.

We’ve long seen a disconnect between sentiment and allocations. Many AAII members have told us over the years that they follow long-term strategies. While some of you do take tactical steps or otherwise adjust your allocations based on market conditions, it has been our observation that this is not universally the case. There is a difference between expecting tougher market conditions and acting on those feelings.

Many refer to Warren Buffett’s advice of being “fearful when others are greedy and greedy when others are fearful.” Our survey lends support to this guidance. Opportunities to buy stocks arise when many others don’t expect them to do well. While the link between unusual levels of bullish sentiment and market performance is not causal, it can be a useful sign to stop and look at the broader market mosaic. Question whether valuations are high or have been discounted. Check your allocation to see if it is still approximately in line with your goals. Consider whether the talking heads, as a group, are sounding overly optimistic or pessimistic. You may find an opportunity to go bargain-shopping or to anticipate below-median returns for the next six to 12 months.

Table 1. Performance of the AAII Sentiment Survey Without Hindsight