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Unusually High Neutral Sentiment Often Followed by Good Returns

by Charles Rotblut | 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

Analyzing the AAII Sentiment Survey Without Hindsight – Here is the 2014 analysis I referenced above. It includes an explanation of how I conducted the analysis.
Investor Sentiment as a Contrarian Indicator – This 2004 Computerized Investing article by Wayne Thorp took an earlier look back at the link between individual investor sentiment and market returns.
Do You Incorporate Sentiment into Your Market Analysis? – Tell us on the AAII.com message boards.

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: 25.0%, down 1.4 points

Historical averages:

Bullish: 39.0%
Neutral: 31.0%
Bearish: 30.0%

Take the Sentiment Survey.

Archives
May 14, 2015 Measuring Pain Relative to Gain

May 7, 2015 Valuations Are Higher, but So Are Margins

April 30, 2015 A Dot-Com Crashes After the NASDAQ Sets a New High

April 23, 2015 Wealth and Spending Affect the Success of the 4% Rule

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