Why Sour Investor Sentiment May be a Good Thing

“Go with your gut.” That approach might be good for choosing items off a restaurant menu or helpful in social situations. But following the adage when you’re investing could lead to costly mistakes. That’s one of the takeaways from some recent analysis done by The Northwestern Mutual Wealth Management Company’s Investment Team looking at the relationship between investor sentiment and future market performance of equities.

In financial markets, investors often have an overall opinion on the future direction of the stock market; they either believe it is headed higher (bullish), will be flat (neutral) or lower (bearish). The collection of these viewpoints is known as market sentiment and there are several surveys out there that measure the general attitudes of investors.

Riding the wave

While the surveys are meant to be forward looking, investor emotions tend to roughly follow the path of the stock market’s movements up and down. When the stock market is rising and their wealth is growing, investors tend to be optimistic. Conversely, when the market is declining and wealth is decreasing, they often become pessimistic. Sentiment tends to follow a wave like this:

One of the most widely watched polls on investor outlook is the American Association of Individual Investor’s (AAII) Investor Sentiment Survey. Each week, members of AAII are asked if they are “bullish”, “bearish” or “neutral” on the stock market over the next six months.

Given the market volatility of the past several months, it’s worth taking a look at where the AAII sentiment index is now and how it compares to historical averages. Not surprisingly, recent turmoil has taken a toll on investor expectations. Outlook readings began to waver as tensions between Russia and Ukraine escalated and in mid- February the poll dipped below 20. Since then, we’ve had four additional readings in the teens including a low of just 15.8 percent bullish in mid-April.  In fact, two of the readings since February are among the 15 worst of the 1,800-plus weekly surveys taken since 1987. The latest results show just 19.8 percent of respondents are feeling bullish, while 53.5 percent think the markets will be down six months from now. That compares to a historical average of 38 percent bullish and 30.5 percent bearish.

Coming into the year, survey results were more in line with historical averages with the final reading of December coming in at 37.7 percent bullish. The natural follow-up question to the data is “Does that mean I should sell out of the markets?” A look at history suggests maybe not.

A case for not following the crowd

As illustrated in the chart below, as pessimism grows, one-year returns and the percent positive trades historically have increased.

Not only has the level of pessimism shown to have an inverse relationship to performance, over time, the worse respondents have felt, the more likely the S&P 500 has been to post gains over the following six-month, one- and two-year periods. For example, when bullishness dips below 20 percent, the S&P 500 has posted positive returns 97 percent of the time on a one-year basis. Digging a little deeper shows that when bullish sentiment falls below 19.2 percent, the rate for positive one-year returns is 100 percent. Keep in mind, we’ve had three reading this year below that threshold and one at 19.2 percent.

Focusing on the percentage of participants who have bullish views on the market for the coming six months can help provide insight into the overall mood of market participants and help pinpoint periods of extreme investor optimism or pessimism. These periods of heightened emotions often are inflection points for equities. When market participants are overly optimistic, they often bid up stock prices as they overestimate growth potential for companies going forward. When those same businesses are unable to meet the lofty expectations, and future gains are limited or performance retreats. Similarly, high levels of pessimism often spark selling pressures and drive expectations and drive valuations lower setting the stage for more opportunity for businesses to outperform tepid expectations.

Sticking to the plan

While the survey has a strong track record as a contrarian indicator, we’d caution that it should not be used as a timing tool for moving in or out of equities. However, it is a helpful reminder of the value a well-thought-out financial plan can provide to help investors from being led astray by their emotions. If you’re concerned about how recent market volatility could impact your financial plan, you should have a conversation with your advisor. However, it’s important to remember that a financial plan prepares you for both the good times and for downturns. While a downturn is possible, there’s also a good chance that the market may not move lower than where it is today. Either way, your plan should give you confidence that you’re ready for a potential downturn if it happens.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources.

All investments carry some level of risk, including the potential loss of all money invested. No investment strategy can guarantee a profit or prevent against loss. Indexes referenced are unmanaged and cannot be invested in directly. Investment examples are for illustrative purposes only and not indicative of any investment.