Indicator of the Week: Why Extreme AAII Pessimism Marks a Buying Opportunity

Pessimism in the American Association of Individual Investors (AAII) sentiment survey is at its highest level since the financial crisis

by Rocky White

Published on Jun 17, 2015 at 8:07 AM

The weekly American Association of Individual Investors (AAII) sentiment survey is showing some extreme pessimism, which -- especially for contrarians like us -- is welcome news. Of all the sentiment surveys we track, the AAII poll is probably the best gauge of the retail investor specifically. That's what makes its pessimistic tilt so promising: Retail traders are exceptionally poor at timing the market. 

How much pessimism is it showing? Looking at a four-week average of the percentage of AAII bulls, it's the lowest reading since March 2009. That's the exact bottom for stocks after the financial crisis. Below is a chart showing the four-week average for AAII bulls, along with the S&P 500 Index (SPX). The yellow dots mark times when the average for bulls falls below 25%. As you can see, three of the last four signals have been outstanding buying opportunities. After the other signal, in 2008, the market was higher by about 5% three months later -- but, of course, holding stocks for any length of time after that would have been awful.

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Quantified Results: I quantified the results on how the SPX performed previously when the four-week moving average dipped below 25%. Looking at the results going back to 1990, you can see why this would excite the bulls. On previous occurrences, stocks on average have immediately taken off and rallied over the next six months. Looking specifically at the three-month returns, the SPX has averaged a gain of 10.9% after these signals, with none being negative. Six months after a signal, the index is up 13.7% on average, with 91% of the returns positive. The returns after a signal have outperformed typical market returns across all the time frames.

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Finally, here are the individual occurrences since 1990. Needless to say, very impressive returns. 

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