Systematic Relative Strength

Why, you may ask, am I writing about investor sentiment from July now that it is mid-September? I think it’s often a useful exercise to look back at the primary sources—the historical data—as my US history teacher used to point out. We all have a way of mis-remembering history. We modify it to fit the present, so that whatever happened seems inevitable. The future, of course, is always uncertain.

Investor sentiment is a peculiar form of history because it generally works in contrary fashion. Studies show that when investors are most bullish, the market tends to go down. And when investors are bearish, the market perversely tends to go up.

July was just such a period. Consider, for example, a CNBC article on the weekly sentiment poll conducted by the American Association of Individual Investors (AAII):

Main Street bulls are fast becoming an endangered species.

Despite the fact that the broad U.S. stock market is up 8.4 percent in 2012, only 22 percent of mom-and-pop investors said they were bullish, the American Association of Individual Investors found in its latest weekly poll.

That’s the lowest sentiment reading since summer 2010, when markets were careening lower in the face of the first post-recession global growth scare and the emergence of Europe’s debt crisis.

But to drive home just how pessimistic Main Street investors have become in the face of a weak U.S. economy, slowing growth in China and continued uncertainty about Europe’s financial crisis, consider that:

• Bullishness now is more depressed than in the fall of 2008, when Wall Street titan Lehman Bros. declared bankruptcy, thrusting the financial crisis into a more dangerous phase.

• The percentage of bulls today is barely above the 18.9 percent on March 5, 2009, just four days before the bottom of the worst stock slide since the Great Depression.

I think it’s fair to say that investor sentiment was pretty negative in July.

So what’s happened since then? All of the bearish investors were not able to make the market go down. Instead, it has risen—the S&P 500 level has gone from about 1350 to 1435!

In fact, this is a typical outcome:

But all the negativity may turn out to be a positive: History shows that super-low sentiment readings tend to act as a contrarian signal. In other words, when everyone is worried, stocks tend to rally.

In fact, according to Bespoke, going back to November 2009, U.S. stocks have posted average gains of 5 percent — with gains 100 percent of the time — in the month after AAII’s sentiment poll showed bullish sentiment readings below 25 percent.

I added the bold to emphasize the cost of bad investor behavior. What if you had exited the market in July because you were bearish? About half of the gains year-to-date have occurred since then. Things always seem darkest before the dawn, but it’s important to resist bailing out when frightened. Better to structure your portfolio so that you can sit tight regardless of the current situation—or to cut back when things seem to be going exceptionally well. It’s tough to get the upside exit right, but it’s relatively easier to flag time periods marked by poor sentiment that are likely to be bad times to get out. If you stay the course, it could make a big positive difference to your returns.