Indicator of the Week: This Signal Called Black Monday and the Financial Crisis

One of the more popular sentiment polls we watch is the weekly sentiment survey published by Investors Intelligence. They obtain a large number of published newsletters, emails, bulletins, etc., that go to clients giving stock market advice. Then they determine the percentage that are bullish or bearish (they also have a third designation of advisors who are expecting a correction). We typically say advisors are showing extreme optimism when the difference between II bulls and bears reaches 40%. The difference is now into the mid-30s, getting pretty close to that level, and could reach 40% by the time you're reading this. Our contrarian philosophy would view this as a sign of caution. Below I'll look at prior instances to see if it is, in fact, a reason to taper expectations.  

Contrarian Indicator: Looking at the Investors Intelligence poll since 1970, I examined times when the bull-bear difference rose above 40%. I only counted each instance if it was the first time rising above this level in three months. The first table below shows how the S&P 500 Index (SPX) performs after these occurrences. For comparison, the second table shows typical S&P 500 returns since 1970.

Supporting our contrarian philosophy, the returns for the index when optimism registers an extreme (as we defined it) shows underperformance across all the time frames, when compared to typical market returns. Three months after a signal -- when the bull/bear difference reaches 40% -- the S&P 500 averaged a loss of 0.3%. Typically, the index averages a gain of about 2% over the same period. One year after a signal, the S&P 500 averaged a gain of just 3.5%, where typically it has averaged a gain of 8.6%.

One thing I was also curious to see was the average positive return and average negative return. According to our philosophy, the extreme optimism could put a cap on upside potential while increasing the likelihood of a huge decline. Again, the data supports our philosophy. Looking at the time frames past one month, the average positive return has been less than typical after the Investors Intelligence poll showed extreme optimism, and the average negative has been greater in magnitude (more negative), as compared to what has been typical. 

Individual Occurrences: Finally, here is a table showing the last 10 occurrences of the poll showing extreme optimism. The last two times, stocks actually did quite well going forward. The SPX gained over 5% in the six months after the 2013 signal, and it gained nearly 9% six months after the 2014 signal. The signal before these was in 2011, just before a significant pullback. Meanwhile, the scariest dates in that table are August 1987  -- just a few months before Black Monday (when the index fell over 20% in one day) -- and October 2007, which almost perfectly timed the market top before the 2008 crash.