How Should Contrarians Handle Extreme Market Optimism?

One of the most popular sentiment polls we watch here at Schaeffer's is the Investors Intelligence's (II) weekly sentiment survey. They collect numerous published newsletters (emails, bulletins, etc.) that give stock market advice to determine the percentage that is bullish or bearish (they also have a third designation of advisors, who are expecting a correction). We say advisors are showing optimism when the difference between bulls and bears reaches 40%. As it stands, readings have been above 40% for the past nine weeks.

Our contrarian philosophy typically sees this as a caution sign. With the S&P 500 Index (SPX) at an all-time high, however, a certain amount of justifiable optimism is expected. Therefore, the implications may not be as bearish. Below, we will break down these specific numbers to get a rough idea of what we can expect from the market going forward.

Here is a chart of the S&P 500, along with the II percentage of bulls and bears in their sentiment poll. The percentage of bullish newsletters is well above 60%, while bearish newsletters were below 20%.

Investors Intelligence at Extreme Optimism

We have II poll results dating back to 1963. The table below shows how the S&P 500 performed after readings above 40%, which is the level we consider optimism to be at an extreme. Stocks underperformed after these occurrences, as expected. One year after readings above 40%, the index averaged a return of 3.5%, with about 60% of the readings positive. Otherwise, it averaged an 8.6% gain, with 76% of the readings positive.

I mentioned above that the implications of II readings may not be as bearish if stocks are near an all-time high. When I break down the numbers, however, it does not confirm that assumption. The first table below summarizes S&P 500 returns after bulls outpace the bears in the II poll by at least 40%, and the index is within 2% of an all-time high. The second table is similar data, when the difference is 40% or more, but the S&P 500 is farther away from record levels.

You can see the results are mixed. When the difference in bulls and bears is 40% or more, the six-month returns are slightly better going forward if the S&P 500 is near an all-time high. A year after the readings, however, the returns are slightly better when the index is not as close to an all-time high. Based on that, the index level doesn’t seem to be much of a factor.

Remember -- the difference between bulls and bears in the II poll has been above 40% for nine consecutive weeks. I am exploring whether the end of this streak is a potential sell signal. There have been seven prior streaks of nine or more weeks, and the table below summarizes how the S&P 500 performed afterwards. The second table shows all other times since 1963, for comparison. Historically, this has been a bearish sign. Stocks have been mostly flat for the next year after these occurrences. A year later, the S&P 500 was positive in just two out of seven instances, with the index averaging a gain of less than 1%.

This last table shows the individual occurrences of streaks ending. On a positive note, in two of the last three occurrences, the index went on to gain double digits over the next year. In all other instances, stocks were lower a year later.