The latest weekly data from the American Association of Individual Investors (AAII) show a continued increase in the percentage of individual investors who are bearish (40.7%) about short-term market expectations and a decrease in the proportion who are bullish (28.1%). The spread between the bulls and the bears is -12.6%, down from +10.1% at the start of September.
There’s no shortage of potential contributors to the wall of worry that has turned investors more cautious, including still-elevated Delta Variant cases, global supply chain issues, third quarter earnings season, increased Chinese regulation, Evergrande solvency, and Federal Reserve tapering. There’s also been on-going drama in Washington over the debt ceiling, the possibility of a government shutdown (now temporarily resolved), and the eventual fate of two major spending bills.
“With the S&P 500 now 5% off its all-time high a lot of individual investors appear to be bearish about the market in the short term” explained LPL Financial Chief Market Strategist Ryan Detrick. “But we believe fears may be overdone and that based on historic readings this pessimism could be a contrarian indicator that’s bullish for stocks.”
As shown in the LPL Chart of the Day, investor sentiment, as measured by the AAII, has slipped significantly since the spring and is now more than one standard deviation below its long-term average.
However, extremes in negative sentiment tend, on average, to be bullish for future returns in the near term (just as extreme optimism tends to be bearish for stocks). When the AAII Bull-Bear is between 1 and 2 Standard Deviations below its long-term average, as it has been for the past three weeks, the average future return one year out has been 11.1%. Caution is still required in interpreting this data as the averages hide a wide range of annual returns (-45% to 66%) and the percentage of returns that are positive one year out is slightly lower (78%) given current pessimistic Bull-Bear spread compared to all data periods (81%). The median S&P 500 return a year out is 14.3%.
Other sentiment indicators that we monitor such as the CNN Fear and Greed Index (itself a composite of seven indicators including market volatility and the average put/call ratio) are also indicating extreme pessimism with that indicator currently showing 25 out of 100, down from 53 one month ago. At extremes, this also tends to be a contrarian signal.
We believe that these levels of investor pessimism may be not warranted and that the wall of worry may start to erode much as it did the last time investor sentiment was this low, which was at the start of October 2020, with stocks having returned over 30% in the year since then.
We are confident Washington’s issues can be resolved: a temporary deal has been reached averting a shutdown;;, a deal should be reached on the debt ceiling; and our base case for government spending bills is around $2-2.5 trillion (funded by $1-1.5 trillion in tax increases). Delta variant cases continue to fall, with the 7-day rolling average down around 20% since last week, and 47 states are seeing low enough rates of spread for cases to continue to fall. While regulatory risk remains elevated in China, we believe there are low odds of contagion from the Evergrande default due to the quality of the collateral and concentrated balance sheets among Asian financial institutions, as well as the Chinese government’s strong control over its economy and markets. While other concerns, like the potential for higher than expected inflation, recent economic data misses, and new COVID-19 variants, remain, we believe the economic environment for stocks looks solid through year-end and well into 2022.
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