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This Key Market Measure Says There’s Reason for Optimism

Although volatility and negativity are dominating the headlines, this collection of sentiment signals says there’s reason for optimism.

Peoples Hands Doing a 'Thumbs Up'

One important tool for contrarian investors looking to gauge the near-term anticipated performance of the stock market is the investor sentiment poll. When retail investors are bullish, that’s typically a signal that the market is fully invested, and stock prices will underperform going forward. If retail investors are fully invested, there’s no further impetus to push prices higher.

By that same token, excess bearishness among investors typically marks elevated short interest. Short covering and changes in perception can trigger major rallies in individual issues or even sectors, especially if that covering is brought about by unexpected positive news.

Putting aside the latest uptick in stock market volatility, a collection of historically reliable sentiment-based indicators suggests a new long-term bull market was born last October. Here we’ll examine the latest in investor sentiment for clues as to what investors can likely expect in the coming 12 months.

One indication of how the contrarian principle is flashing a bullish signal for the longer-term outlook is found in the fact that, despite a significant rally in stock prices during the past four months, NYSE margin debt (loans using equities as collateral) has been in a steep and steady decline.

NYSE Magin Debt Chart

Whenever this has happened in the past, it has typically served as a harbinger for above-normal returns in the S&P 500 over the longer term, as noted by market statistician Jason Goepfert.

An additional piece of evidence pointing to a significant bottom being established is found in a February 12 article from the Wall Street Journal, which noted that investors have recently exited U.S. equity mutual funds and ETFs in record numbers in favor of international funds. According to WSJ:

“Investors have pulled a net $31 billion from U.S. equity mutual funds and exchange-traded funds in the past six weeks, according to Refinitv Lipper data…That marks the longest streak of weekly net outflows since last summer and the most money pulled in aggregate from domestic equity funds to start a year since 2016.”

As with declining margin debt, heavy investment fund outflows among small investors normally precede long periods of outperformance for equities. Indeed, the reluctance of retail investors to commit to the bullish argument for U.S. stocks is a further argument—from a contrarian perspective—that the crowd is likely wrong and the uptrend in stocks has legs.

Providing additional support for the bulls’ case is the recent trend in investor sentiment as measured by the American Association of Individual Investors (AAII) weekly polls. As shown in the chart below, the trend in AAII bulls minus bears has entered positive territory for just the second time since last March, and has accelerated above 10% net bullish for the first time since 2021 (when bull market conditions still prevailed).

AAII Bulls-Bears Graph

Normally, whenever this indicator thrusts strongly positive after spending several months in negative territory, higher stock prices follow over the next 12 months or longer.

It should be noted by way of caveat, however, that while the above indicator can be viewed as a bullish omen for the longer term, the near-term stock trading environment could be choppier and possibly indecisive (i.e., rangebound) following such a dramatic shift in sentiment and the market-dominating news headlines we’re seeing today.

Dean Christians of SentimenTrader alluded to this in a recent missive when he pointed out that the Investors Intelligence (II) sentiment survey released last month showed the percentage of bullish investment advisories has climbed to its highest level in over a year. He observed the Investors Intelligence recovery occurred from a level normally associated with “significant stock market lows.” Christians also cautioned:

“When the [percentage] rank for the II [percentage] bulls survey cycles from greater than 10% to less than 60%, the S&P 500 tends to see some follow-through in the near term. However, the 2-month window suggests the market could consolidate its recent gains” and “could be bumpy.”

The good news, however, is that the longer-term (12-month) outlook “looks excellent” according to Christians, with only two false signals over a period of several years.

S&P 500 Graph

Viewing the pieces of the investor sentiment puzzle collectively, it appears that most investors aren’t buying into the recovery rally of the last four months. And from a contrarian perspective, that’s welcome news since it increases the odds the recovery has legs.

Bear market rallies (which tend to be short-lived) often see an increase in enthusiasm among participants, while legitimately bullish rallies tend to be greeted with skepticism, hence the old Wall Street saying: “Stocks climb a wall of worry but descend a slope of hope.”

With this in mind, investors should be careful of focusing too much on short-term periods of heightened volatility and succumbing to pessimism. Instead, remember to focus on the longer-term investment horizon, which looks increasingly sunny after last year’s stormy skies.

For over 20 years, he has worked as a writer, analyst and editor of several market-oriented advisory services and has written several books on technical trading in the stock market, including “Channel Buster: How to Trade the Most Profitable Chart Pattern” and “The Stock Market Cycles.”