In my recent post, I averaged the bullish stock market sentiment from three well-regarded and longstanding surveys and found unprecedented bullishness during the past two years. My latest article for Trading Markets found that the peaks and valleys of sentiment across the three surveys have tracked intermediate-term market swings quite nicely. A chart of those data can be found on the 11/7 Trading Psychology Weblog.
Going back to mid-1987 (N = 1006 weekly periods), I created a composite measure of investor sentiment by averaging the bullish percentages from the American Association of Individual Investors survey, the Investors Intelligence poll, and the survey from Market Vane. Over that period, these measures of sentiment are positively correlated with each other, but do not have huge areas of overlap. The AAII and Investors Intelligence polls are most closely related, with a correlation of .52. Those two polls correlate with the Market Vane measure by only about .26. Altogether, the polls share less than 30% of the total variance in reported sentiment. That suggests to me that the surveys may be tapping different kinds of traders: some shorter-term, some longer-term, some index traders, some traders on individual equities.
By averaging the three surveys and focusing on when they are all bullish or bearish, we can obtain a good sense for when a variety of traders are leaning the same way in the market.
What we find in doing so is that, since 1987, the 2004-2006 is unprecedented in its persistent bullishness. Specifically, the average bullish percentage from 2004-2006 has been 53%. The average bullishness from 1987-2003 has been 43%. To put that into perspective, 71% of all weekly periods since 2004 have seen bullish readings over 50%. Prior to 2004, only 20% of readings exceeded 50%.
But now the big question: Does investor sentiment have an impact upon future price changes?
When composite bullishess has exceeded 55% (N = 108), the next 10 weeks in the Dow Jones Industrial Average have averaged gains of only .57% (60 up, 48 down). That is considerably weaker than the average ten-week gain of 1.70% (640 up, 366 down) for the entire sample. Indeed, when bullishness has exceeded 60% (N = 22), the next ten weeks in the Dow average a loss of -2.51% (7 up, 15 down)--a remarkable finding, given the long-term bullish bias in the Dow over that period.
How about when bullishness has been below 40% (N = 308)? The next ten weeks in the Dow average a robust gain of 3.0% (217 up, 91 down)--much stronger than average.
It does, indeed, appear that investor sentiment possesses some contrary value. Consider the outcomes when we look 20 weeks out: When sentiment is bullish (over 55%), the average gain over the next year is a subnormal 1.44%; when there are relatively few bulls (under 40%), the average gain is a robust 5.34%.
The present market, hovering near that 60% level, has some uncomfortable company in market history, including January, 2000; April, 1998; and August,1987. Not every period of very high bullishness has led to a market crash, but only 6 of the 22 highly bullish periods were higher 20 weeks later. And that's no bull.