The Investment Scientist

Investor sentiment and stock market return

Posted on: March 27, 2008

Investor sentiment is at its lowest since 1990 and second lowest since the American Association of Individual Investors (AAII) sentiment indicator began in 1987. On 2/7/08, the 8-week moving average bull/bear spread reached the low of -25% and has since hovered below -20%. What does it mean for investors that the bull/bear spread stands at -25%? And what is the bull/bear spread?

Are you bullish, bearish, or neutral?

That’s the question asked by the AAII who has been conducting weekly market-outlook surveys of its members since 1987.

The bull/bear spread is the bullish percentage of the answers minus the bearish percentage of the answers. For instance, if 30% are bullish, but 50% are bearish, then the bull/bear spread would be 30%-50%=-20%. Since investor sentiment is very votalile, the 8-week moving averaging is used to smooth out the kinks. The AAII has 20 years of data with which we can study the relationship between investor sentiment and stock market return.

Current low investor sentiment is significant because there were only six instances (excluding this one) when it was below -15%. And only two instances when it was below -20%.

How does bearish investor sentiment relate to stock market return?

I used the small sample of six prior occasions when the bull/bear spread was below -15%. I then studied the subsequent one-year returns by the S&P 500 and the Fama/French Small Cap Value Benchmark Portfolio. The result is displayed in the table below.

Time (8 weeks ending on ) 8 week MA bull/bear spread S&P 500 one year return Small Cap Value one year return
11/2/1990 -37% 25% 46%
2/7/2008 (this time) -25% ?% ?%
10/23/1992 -21% 12% 40%
3/13/2003 -18% 40% 82%
7/2/1993 -15% 0% 11%
7/20/2006 -15% 23% 23%
3/16/1990 -15% 9% -2%
Average -20% 18% 33%

Data sources: AAII, Kenneth French data library

History shows that the worst decline is over once the indicator shows a reading of -15% or below.

One-year returns for the S&P 500 ranged from 0% to 40%, while those for the Fama/French Small Cap Value Benchmark Portfolio ranged from -2% to 82%. To the extent history repeats itself, the risk rewards of stock investing is heavily skewed toward rewards.

Warren Buffet put it best when he said: “Be greedy when others are fearful.”

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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