Inspired by the postings Sentiment, by Timothy Roe and Pessimism, from Victor Niederhoffer on the Daily Speculations website, I decided to investigate these observations in more detail.General market sentiment tends to lead investors down the wrong path. There exists a negative relationship between the sentiment of the American Association of Individual Investors (AAII) and future Dow Jones Industrial Average returns.

The AAII has been conducting a weekly sentiment survey of its members since July 1987. It asks respondents to categorize themselves as Bullish, Bearish or Neutral. They then assign a percentage to each group from the total sample. (For the purpose of this study, I use the percentage of Bearish individuals as a gauge of investor sentiment.)

Since 1987, the average percentage of Bearish individuals is 28.31% with a standard deviation of 9.25%. For the week ending 21/07/06, the Bearish percentage stood at 58%. That is over three standard deviations from its mean. Indeed, a very high percentage of Bearish individuals. With this in mind I decided to record all the occasions whereby the Bearish Individuals measure, strayed three standard deviations from its mean, to roughly 56%.

There have been 8 occasions when the AAII percentage of Bearish individuals recorded a score of 56% or more and 12 months later the DJIA was up on average by approximately 20%, with a t stat of 2 and a win rate of 100%. The percentage return is almost double that of all other rolling 52 week periods. In reality the data slightly overstate forecast returns and does not approach statistical significance due to some overlapping and clustering of data. However, the data are suggestive of much higher levels for the DJIA 3, 6, 9 and 12 months out.

I also decided to test future returns when the percentage of Bearish Individuals fell between three and two standard deviations from its mean or roughly 56% to 46%. For mine, still a relatively high outcome. The data in this group were consistent with the previous findings that a high level of Bearish sentiment is positive for future returns. I found 33 occasions that produced a 12 month average return in order of 15%, with a t stat of 2 and a win rate of over 85%. Again the data are somewhat overstated due to overlapping and clustering of data, but the general picture appears to be positive.

Interestingly, if we include the reading of 58% recorded on 21/07/06, then 8 times out of 9, three standard deviation observations occurred when military conflict was omnipresent in the mind of investors.

Six readings of greater than or equal to 56%, occurred between August and October 1990, a time when Iraq invaded Kuwait. The DJIA never traded below its October low again.

A reading of 56% was recorded in October 1992. The month’s news was heavily dominated by the US Presidential campaign. Again the DJIA never traded below its October low.

In late February 2003, Bearish sentiment was at 58%, approximately one month before coalition forces invaded Iraq. The first week of March marked the low for the DJIA, a low that till this day has not been breached.

The recent reading of 58%, recorded in late July 2006, coincided with the Israel & Lebanon conflict, & the DJIA trading at 10,868. Perhaps this could be a multi year low. We will find out over time.

The data are consistent with Lord Nathan Rothschild’s musing that he liked “to buy when the cannons are thundering and sell when the trumpets are blowing”, circa 1810.

For Australian investors the data are also suggestive of positive things to come. Of the 8 times that the AAII percentage of Bearish individuals was equal to or above 56%, the All Ordinaries Index gained on average 16.58% over the next 12 months versus all other rolling 12 month returns of 7.03%. Just over double the average, with a t stat in order of 2 and not one negative 12 month period.

Maybe our Bear will not be depressed for too much longer, because he can be associated with an up stock market.

James Tar objects:

The foundation “Bear Sentiment as a Contrarian Indicator” rests on is flawed. Mr. McCauley makes an obvious mistake. What needs to be considered is that everyone is finally looking at Bull/Bear Sentiment Gauges these days to help formulate an opinion on market direction. Present market chatter, and everyone is saying it, is “The Bear Sentiment is so high we cannot go lower.” Everyone is fixated on this, so much so that the herding on the weekly polls and data (AAII releases) for a contrarian indication of market direction should be a clear warning to the speculator that such a method has now become extinct. The market has perhaps outsmarted once again. Meaning, it might be time to look to these polls as confirmation.

I deeply regret writing such bearish commentary. But if we are truly going to advance our study and discussion of the markets, such a reversal in the foundation of such a widepsread utilisation of “contrarian indicators” must clearly be considered.

Andrea Ravano comments:

I have seldom seen so much negative feeling and low expectations in stock markets, than those surrounding me at present. Private bankers from here and there (I will not mention the countries the calls come from, because I am afraid to offend) mention again and again the risks of war in the Middle East, the price of oil, the risk of inflation etc.. The consensus seems so large that I am a bit puzzled by the market show of strength relative to the so many, possibly sidelined, if not straight short investors.

Which, of course, leads me to believe that if nothing unreasonable happens in terms of terrorism, we might see world stock markets rally by year end, if not sooner.


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