INVESTOR SENTIMENT SURVEYS: DON’T BE TOO SENTIMENTAL!

Measures of investor sentiment are popular because they are often considered reliable contrarian indicators. The evidence does not support their popularity.

Investors Intelligence

The best known is the Investors Intelligence index, created in 1963. It studies more than 100 regularly published advisory investment newsletters, assessing their stance on equity markets. The web site claims that

Since its inception in 1963, our indicator has a consistent record for predicting the major market turning points.

We don’t necessarily take a contrarian view to the newsletter writers in our survey. A large part of the time our sentiment readings remain neutral. We consider the norm to be 45% bulls, 35% bears and 20% neutral. However, we do pay attention to extreme readings in both bulls and bears and also to historically significant runs of more bulls than bears. To summarize, advisors are only wrong when you get too many of them start thinking the same thing.

I have analyzed 30 years of data plotting the II bull-bear % difference against the DJ Total Stock Market Index of 5000 US stocks. Extreme readings are above +/-25%. However, I have easily identified 11 periods when the “contrary” indicator rose to cross the extreme +30% level which were followed by strongly rising markets. Obviously not useful on that side of the ledger.

There were only 9 extreme negative readings (bullish signals) since 1980. The numerous 1981-82 readings <-25%, taken together, could be seen as indicating a major bottom, but only if you survived the 3 false signals between the fall of 1981 and the actual mid-1982 much lower low. The 1988 signal was good. The early 1990 signal was too early but the one in mid-1990 was excellent. The two signals in 1994 proved great, like the ones in late 2008.

Overall, never mind the extreme positives, they are essentially useless. The extreme negatives (bullish) are few but generally very good although some require patience and staying power.

For current readings of the II survey: Market Harmonics

AAII Sentiment Survey

Every Thursday, the American Association of Individual Investors releases the results of its Internet survey—which asks AAII members to register their bullish, bearish or neutral views on the stock market—early each Thursday. Excerpts from the WSJ:

(…) Over the past two decades, it has proved a compelling contrarian indicator: If the reading is overly bearish, for instance, it is often a sign the market will rally.

(…) the survey’s sample size is typically so small, and its methodology so fraught with holes, as to render it statistically worthless.

Just 200 to 300 investors respond each week, less than 0.2% of the association’s 150,000 dues-paying members, according to the Chicago-based group, which doesn’t publish the sample size. Among them are a large number of retirees, the AAII says—giving this tiny slice of the investing community an unusual amount of sway over Wall Street.

From a strict, statistical perspective, the AAII’s survey is “pretty much useless,” said David Madigan, professor and head of the Department of Statistics at Columbia University, who is particularly troubled by survey’s reliance on voluntary self-reporting.

“The thing you worry about is the bias of the people who volunteer. The concern is, why would someone choose to respond to this?” Prof. Madigan says. “If you were using it to make statements about how the general membership feels, then you’re on really shaky ground. But maybe the opinions of the 200 who are motivated enough to respond is predictive of what the markets are going to do.”

The real questions are: this indicator being such a “famous” contrarian signal, voters must know that their collective wisdom is read upside down. Why vote? Can anyone vote objectively?

And despite its formidable statistical limitations, the survey has been surprisingly useful as a marker of turning points, especially market bottoms. (…)

Birinyi Associates has been following the survey for years, using the difference, or spread, between the bulls and the bears as an indicator of where the market may head. Birinyi uses a four-week moving average. The results are noteworthy: On the 16 occasions since the early 1990s that bears have outnumbered bulls by at least 10%, the Standard & Poor’s 500 has gone on to rally an average 6.2% gain over the next six months.

And when optimism gets too frothy, and bulls outnumber bears by at least 30%, the S&P 500 has tended to fall over the next six months, according to Birinyi. The current run of bullishness hasn’t gone that far yet, but the numbers are quickly approaching those levels.

Interestingly, Birinyi’s criterias result in many more bearish readings (bullish signals) than bullish readings (bearish signals). It gave 6 bullish signals and only one bearish one between 1988 and 1996, missing the 1990 bear market. Between 1996 and 2002, Birinyi’s criteria gave plenty of bearish signals and only one bullish one, erased soon after. The early 2003 bullish signal was bang on but quickly morphed into a bear! Back to bull in 2005 but back again to bear before year-end. That was the last bearish signal since. Strict AAII bull/bear ratio followers have been bullish since 2006!

In all, how useful is that?

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