Is Investor Optimism Ringing Alarm Bells?

It's no secret that stocks have been on a tear since the U.S. election, with the Dow just wrapping up its longest weekly winning streak of 2016. Against this backdrop, traders are rushing into stocks -- and out of bonds -- at a rapid-fire rate, a record $97.6 billion has been funneled into U.S. equity exchange-traded funds, and optimism is on the rise. What's more, if history is any indicator, one sentiment signal could point to short-term speed bumps -- but long-term gains still ahead.

The number of self-identified bulls in the American Association of Individual Investors (AAII) survey has been at or above 40% for five straight weeks now, and is within striking distance of a three-year high. Further, the 10-week average of bullish sentiment is now at its highest point since April 2015. But where did these bulls come from? Prior to the election, more than 40% of AAII respondents fell in the "neutral" column; that number has since dropped to its lowest point since November 2014, at 32.3%.

According to Schaeffer's Senior Quantitative Analyst Rocky White, when the retail crowd suddenly shows more conviction, the S&P 500 Index (SPX) tends to suffer in the near term. Specifically, going back to 1987, when the AAII "neutral" reading plunged below 25% after at least six straight months north of that level, the index averaged losses of 0.6% and 0.54%, respectively, two weeks and one month out. That's compared to anytime gains of 0.33% and 0.66% in the same respective time periods. What's more, after these 10 signals, the S&P has been positive 50% of the time -- less than usual -- going out one month.

However, the SPX has been positive a whopping 90% of the time, looking three and six months after a severe depletion of "neutral" respondents. The index averaged a three- and six-month gain of 3.77% and 7.96%, respectively, handily outperforming the S&P's average anytime returns in those same time periods. And volatility tends to be lower than usual, too, looking at standard deviation.

 

On the other hand, contrarians won't be surprised to find that the S&P tends to perform much better when once-neutral investors flock to the bearish camp, as opposed to the bullish. Historically, this mass movement from the "neutral" category has been split down the middle, with half resulting in a flood of optimism, and half in a bearish bombardment.

After a switch to "bullish" sentiment, the S&P has averaged a loss looking two weeks and one month out, and slimmer returns three and six months out, compared to a switch to "bearish" sentiment. In fact, when once-neutral AAII respondents turn bearish, the S&P has been positive 100% of the time looking three and six months out. Further, the SPX tends to be much more volatile after a bullish switch, compared to a bearish -- again, as measured by standard deviation.

In conclusion, the AAII "neutral" reading hasn't yet breached 25%; in fact, we're still in the midst of the longest stretch of "neutral" readings above 25% on record, at 108 weeks. And while the growing optimism on the Street is certainly on our radar, it's not yet ringing alarm bells for the bulls to hit the bricks and defy December seasonality. As Schaeffer's Senior V.P. of Research Todd Salamone noted earlier today, "If you are a short-term trader, be open to trades on both the short and long side of the market. If you are a long-term investor, do not disturb your bullish positions."


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