What to Expect as Sentiment Turns Less Bullish

Sentiment is starting to sour despite the S&P 500 Index (SPX) trading at all-time highs, according to the weekly Investors Intelligence sentiment survey. Even though there was a 3% pullback in the second half of January partly due to uncertainty surrounding the coronavirus, the significant drop in sentiment seems unwarranted. The spread between the bulls and bears in the most recent survey fell below 30% for the first time since last September, and the percentage of bulls fell below 50% for the first time since October. Below, I study historical instances when sentiment crossed below these thresholds for the first time in weeks.

Sentiment Falls from Bullish to Less Bullish

The sentiment in this poll is nowhere near bearish, but given the strong stock market right now, you would expect it to be showing significant optimism. You can see in the chart above the bulls minus the bears line has fallen below 30% for the first time in several months. It is now in line with its historical average.

We have data on this poll going all the way back to 1963. Since then, I found every time the bulls minus bears fell below the 30% level for the first time in at least three months. The table below summarizes how the S&P 500 performed afterwards. The second table below shows anytime returns for comparison.

It’s kind of a mixed result. The average return underperforms typical returns going forward except in the shortest timeframe, but the percent positive is higher than typical. These signals seem to foreshadow a slow moving rising market.

I wondered if anything changes when you look at the signals generated when the S&P 500 was near an all-time high. Since you expect a higher level of optimism with the stock market near all-time highs, I thought including only these signals would tend to capture times where the sentiment drop was unwarranted. When sentiment is more bearish than the market justifies, that would indicate a buying opportunity. The table below shows the returns after these signals occur with the S&P 500 within 5% of an all-time high.

This method returns six signals and the data does not support the theory I just posited. The long-term one-year return is slightly more bullish than typical, but the shorter-term returns are significantly more bearish than otherwise. In these instances, it seems investors turned bearish at the right time.

Here’s one more way I looked at it. It’s similar but instead of looking at bulls minus bears, I only considered the percentage of bulls. I mentioned above that the bulls fell below 50% for the first time since October. The table below shows the S&P 500 returns after the bulls fall below this level for the first time in at least three months.

This approach gives 22 signals, and they seem like the bulls minus bears signal above. They’re similar in the sense that the returns tend to be positive but at a lower average return than what the market typically returns. These signals have tended to occur before periods of low volatility as measured by the standard deviation of returns.

Again, I filtered out only the signals that occurred with the S&P 500 Index within 5% of an all-time high. When you consider only the percentage of bulls rather than the bulls minus bears, the returns are more what I expected. The returns going forward are finally more bullish than typical.

So, I looked at it one way and it showed a tendency for bearish returns and then another way that showed a tendency for slightly bullish returns. As a contrarian, I’m encouraged that there’s evidence of pessimism being shown, but the empirical studies are mixed as to what to expect going forward.