Stocks Just Did This for Only the Second Time Since 1929

Too much investor optimism has bearish implications for stocks

Senior Quantitative Analyst
Jul 5, 2017 at 9:55 AM
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The first half of 2017 is in the books, and it was a good first half for stocks. The S&P 500 Index (SPX) gained over 8%, closing at all-time highs on 24 separate occasions. Furthermore, the biggest close-to-close drawdown through the first six months was less than 3% for only the second time since 1929. This week, I'll dig into that impressive statistic to see what it might mean for the second half of the year. Finally, I'll see if investor sentiment is getting a little too optimistic.

Smallest Max Drawdown Since 1995

One of the more impressive stats through the first half of the year is the maximum close-to-close drawdown of the SPX. From March 1 through April 13, the index lost 2.8% of its value. Historically, that's just a blip of a pullback, but this year, it was the biggest loss suffered. As you can see in the table below, only one other year had a smaller maximum drawdown. This was in 1995, where the drawdown only reached 1.7% in the first half of the year. The S&P 500 Index went on to gain 13% in the second half of that year.

                                               SPX small 1H 1

The table below summarizes the second-half returns based on these maximum drawdowns. Historically, when the first-half drawdown was less than 5%, the market performed very well in the second half. The S&P 500 Index has averaged a 7.84% return in these circumstances, and more impressively, 81% of the returns were positive.

Also, when the max drawdown has been low in the first half, the losses in the second half have tended to be trivial. When the first-half drawdown was less than 5%, the average negative return in the second half was barely above 2%. Otherwise, the average loss was double-digits. Based on these numbers, the second half of 2017 should be a good one for investors.

                                     SPX 2H returns

Investors Intelligence Bulls Run Rampant

Another notable statistic from the first half is not as encouraging. The average percentage of bullish advisors in the weekly Investors Intelligence sentiment survey was 56.2%. This is the third highest on record dating back to 1964, the first full year of data we have. Excessive amounts of optimism tend to have bearish implications for the market going forward. As the saying goes, "be greedy when others are fearful and fearful when others are greedy."

The table below shows the years where the average first-half bullish percentage from the Investors Intelligence poll was above 50%. This year, 2017 ranks third on this list. Recall from the previous section, those years with minor drawdowns tended to have strong second-half performances. Those years listed in the first table that also made it into the table below are highlighted in orange.

It's interesting that while 81% of those small pullback years were positive in the table above, of the four years that made it into the table below, two were negative in the second half. This is evidence that investor optimism has bearish implications.

                                                II bulls 1H

Finally, the table below summarizes the second-half returns based on the average percentage of II bulls in the first half of the year. When the average bulls reached 50%, the SPX averaged a slight loss in the second half of the year, with just half of the returns positive. This underperforms the returns in the alternative brackets. 
                                              SPX 2H returns II

In conclusion, the first-half's steady, consistent gains are typically a good sign for the second half of the year. However, we must be cognizant of signs that expectations are getting a little too high.

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