Sentiment Signal Calls For Caution From Stock Buyers

The market seems to only go up anymore. The S&P 500 Index (SPX) hasn't suffered a down day yet in 2018, and when things are going this well, it's an appropriate time to examine some sentiment indicators. The American Association of Individual Investors (AAII) sentiment survey has displayed some interesting behavior lately. The survey polls individual investors on whether they are bullish, bearish, or neutral over the next six months. Optimism is spiking according to this poll, which isn't that surprising given the performance of stocks recently. During the current bull market, which has gone on for eight-plus years now, the survey was showing stubbornly low optimism by some measures.

AAII Survey is a 'Huge Caution Sign'

In the latest AAII survey, nearly 60% of investors were bullish on the market, with just 15.6% bearish. The difference between the bulls and bears spiked above 40% for just the second time since 2010. Going back as far as we have data on this poll (August 1987), the difference between the bulls and bears is in the 96th percentile of readings. I would call that extreme optimism.

Historically speaking, this is a huge caution sign for stocks going forward. The tables below quantify the returns of the S&P 500 going forward after the poll reaches extremes. I defined an extreme as in the top or bottom 10% of readings going back to 1987.

When the reading is very optimistic, like we're seeing right now, the index averaged a loss over the next six months, with just 56% of the returns positive. Other times, around 75% of the returns were positive, with the SPX averaging a gain of 4.5% when the survey was moderate, and above 7% when it's showed extreme pessimism. Over the next year after AAII investors became extremely optimistic, the S&P 500 was essentially flat, with 63% of the readings positive. That underperforms other times substantially.

SPX After AAII Bulls Top 50%

Here's another aspect of this survey which gives us more hope. In the second part of December, AAII bulls moved above 50% for the first time since the beginning of 2015. The bullish reading spent 154 weeks below 50%, which was by far its longest streak ever. The table below lists other times the reading broke above 50% after at least a year below it. This is the third such streak since the beginning of the current bull market. Stocks performed well after those two instances.

Here's a table that summarizes the returns above. The second table below shows typical returns since 1989. SPX returns outperform the anytime returns, though it's a very small sample size. The bullish theory is that the extended amount of time with the bulls below 50% indicates a sizable portion of investors sitting on the sidelines. The spike above 50% is the capitulation of those sideline investors. If this is, in fact, the case, the recent rally makes a lot of sense -- and it might be just the beginning.