Sentiment and the Holy Grail

Sentiment hit a number of bearish extremes last week and I tweeted out a few charts illustrating this shift in the mood of market participants. The most striking of these was the percentage of Bulls in the AAII (American Association of Individual Investors) poll dropping down to 17.9%, below the extreme low it reached in March 2009 (18.9%) after a 57% decline in the S&P 500.


The immediate response on twitter was predictable: 1) subjective opinions that there was not “enough fear” yet, 2) that the fear was more than justified because of xyz bad news (imminent recession, china, crashing oil, etc.), and 3) the times in history when sentiment was bearish and the market continued to go down.

I know better than to try to have an intelligent discussion via twitter, so let’s go through each of these responses here.

First, there is no way to test one’s subjective view of fear and greed. It is meaningless. While admittedly not perfect, sentiment indicators at least provide an objective measurement with data going back in time.

Second, high levels of fear are always associated with a lot of bad news. That is the nature of markets. When markets are down, we find reasons (whether true or not) to rationalize the declines. They always seem justified at the time but the question for markets is of course 1) how much bad news is already priced in, and 2) will the news ever get better (it usually does).

Lastly, in terms of the false positives (when sentiment is bearish and the market continues to go down): there is no holy grail. There is no indicator – sentiment, valuation, momentum or otherwise – that will be “correct” 100% of the time.

Does that fact render sentiment analysis useless? Only if you require 100% certainty in markets in which case you would never invest because such a thing does not exist. There are only probabilities in investing, and when sentiment is extremely bearish, the risk/reward has generally improved and your probability (not certainty) of higher future returns has increased.

Let’s examine the data.

The AAII Sentiment poll has been in existence since 1987. Since then, the percentage of Bulls has been below 26% only 10% of the time (the current condition). On the other side of the sentiment extreme, it has been above 52% only 10% of the time (we last saw this extreme in late 2014). (Note: sentiment analysis is only meaningful when at extremes; most of the time sentiment is telling you nothing about risk/reward or the likelihood of higher/lower future returns).

The table below shows the average forward returns after each of these conditions, extreme greed (above 52%) and extreme fear (below 26%). The table also shows the average forward returns for all periods.


What can we conclude from the tables above:

1) Extreme fear seems to lead to above average forward returns and a higher probability of a positive forward returns.

2) Extreme greed seems to lead to below average forward returns with a lower probability (though still above 50%) of a positive forward return.

3) While the market is often positive one year after extreme fear readings (90% of the time), it is not always positive. Again, there is no holy grail indicator and there have been times in history (during bear markets like 2007-09) when sentiment got very bearish (January 2008) and stocks continued to decline.

We’ll only know in hindsight if the current bearishness is coinciding with a correction within an ongoing bull market or something more like the 2008 scenario. Regardless of your view, though, one thing is clear: the risk/reward and odds of higher S&P 500 returns are better today with the S&P 500 at a recent low of 1812 than when bullishness was rampant last year at the all-time high of 2134.

As I said last week on CNBC, when it comes to investing, it is not greed but fear that is good. With all due respect to Gordon Gekko, of course.

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This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by Pension Partners, LLC in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. Pension Partners, LLC expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.



Charlie Bilello is the Director of Research at Pension Partners, LLC, an investment advisor that manages mutual funds and separate accounts.  He is the co-author of three award-winning research papers on market anomalies and investing. Mr. Bilello is responsible for strategy development, investment research and communicating the firm’s investment themes and portfolio positioning to clients. Prior to joining Pension Partners, he was the Managing Member of Momentum Global Advisors previously held positions as an Equity and Hedge Fund Analyst at billion dollar alternative investment firms.

Mr. Bilello holds a J.D. and M.B.A. in Finance and Accounting from Fordham University and a B.A. in Economics from Binghamton University. He is a Chartered Market Technician (CMT) and a Member of the Market Technicians Association. Mr. Bilello also holds the Certified Public Accountant (CPA) certificate.


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