Gauging investor enthusiasm

Chas Craig, BridgeTower Media Newswires

“While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster.”
— Benjamin Graham

Warren Buffett counseled in his 2005 letter to Berkshire Hathaway shareholders that “Investors should remember that excitement and expenses are their enemies. And if they insist on trying to time their participation in equities, they should try to be fearful when others are greedy and greedy when others are fearful.” The dichotomy between the ease of understanding this concept and the difficulty of practicing it is unmatched. The reason, investors are all too human. As we have outlined several times in the past when discussing behavioral finance, the same instincts that protect us from physical harm and make us more tolerable to our fellow man seem to run counter to our financial well-being.

Saying, “do not be so human” is probably not very useful advice though. Fortunately, a variety of sentiment indicators exist that can give us a rough estimate of just how greedy or fearful other market participants are feeling. While sentiment indicators are likely more noise than signal most of the time, they do seem to have utility when large deviations from the norm occur.

One of my favorite sentiment indicators is the American Association of Individual Investors (AAII) Sentiment Index. Since 1987 AAII members have been answering the same simple question each week: Are you bullish, bearish, or neutral on the stock market over the next six months? Unsurprisingly, maximum bullishness of 75.0% was reached in January 2000, near the apex of the dot-com bubble, one of the greatest hysterias in human history. Maximum bearishness of 70.3% occurred in March 2009, which in hindsight was a once-in-a-generation buying opportunity. Alas, the instincts that make us not want to leave a fun party early or encourage us to run out of a burning building, which make us more fun to be around and safer respectively, prove disastrous again and again when it comes to investing.

Side Bar: The minimum percentage for the “Neutral” response occurred in October 2008 at 7.7%. This minimum neutral response could also be thought of as maximum certainty (bull or bear) amongst survey respondents, a laughable outcome given how uncertain things truly were at that time.

Getting back on track, the current bullish reading of 48.1% is a far cry from the dot-com bubble days, but it is meaningfully above the since-inception average of 37.9%. For those with a statistical itch to scratch, the AAII provides its data in a very useful spreadsheet on its website (www.aaii.com) that points out that the current reading is just outside one standard deviation from the long-term mean.
While the average investor’s bullishness is notable just now, is it extreme enough to call it signal? Or is it just noise?

Bullish readings of over 50% (close to the current level and a little more than one standard deviation from the mean) are not all that uncommon, occurring 12.5% of the time since 1987, and the forward six-month total return for the S&P 500 following each index reading over 50% was positive two-thirds of the time. Having said that, the average six-month return was just 1.7%, and it was negatively skewed with a range of -32.6% to 22.8%. Readings over 60% though, are much rarer, occurring in just 2.6% of the periods observed, consistent with the statistical occurrence of two stand deviation outcomes. Still, even though the average six-month forward return was only 0.59% when bullishness exceeded 60%, returns were positive a little more than half the time. Here too though, the return series was skewed negatively (-20.6% to 16.0%).

Two takeaways: First, there are no panaceas, and sentiment indicators, like everything else, should not be viewed in a vacuum. Second, two standard deviation from the mean outcomes tend to be worth waiting for.

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Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).