Do the Opposite
In a legendary Seinfeld episode, George Costanza's life takes a turn for the better when he admits his instincts are wrong and he starts "doing the opposite." Investors might become more successful if they stopped following their instincts and started doing the opposite of the Wall Street herd.
Market sentiment is simple to understand and easy to use. In a nutshell, when everyone is bullish or bearish on a particular asset, it may be time to do the opposite. That is, if the herd is bullish on technology, or housing, or commodities, it probably means that these areas of investment should be avoided, and at some point, shorted. Why? Because when markets get overheated, momentum takes over and funds are thrown at any asset class that is outperforming, regardless of the fundamentals. Eventually, too many people are sitting on the same fence - and the fence breaks. The key to market sentiment is to take advantage of this momentum, but not to be the last one out of the room.
Two market sentiment polls that recently moved to bearish extremes are the American Association of Individual Investors (AAII) poll and the Investor's Intelligence (II) poll. The AAII sentiment survey asks its membership weekly where they think the market will be in six months. The responses are grouped into three categories: bullish, bearish, or neutral. The Investor's Intelligence (II) survey, administered by Chartcraft and edited by Michael Burke, polls 140 investment newsletters and determines whether the publisher is bullish, bearish, or neutral.
During the latest market bottom in June and July, we saw a major shift in sentiment to the bearish camp. During the week of July 21, bearish sentiment in the AAII poll rose to 57.8%, the highest reading since February, 2003, while bullish sentiment fell to 23.9%, the lowest since April, 2005. Bullish sentiment in the II poll fell to 35.6% in June, the lowest since October, 2002, while bearish sentiment rose to 37.1% in August, the highest since March, 2003. During the week of June 23, sentiment was at a standstill, with bulls and bears both at 35.6%. This was the first time that bearish sentiment was as high as bullish sentiment since October, 2002.
We believe that for the market to continue higher, the bears need to throw in the towel and move quickly to the bullish side of the fence. This has yet to happen. During the final market low in March, 2003, bullish sentiment in the II poll fell to 39.8% and bearish sentiment rose to 38.2%. As the market came out of that low, the bears quickly turned bullish, and in just five weeks, bullish sentiment rose to 51.1% and bearish sentiment fell to 30.3%. Since June of this year, we have seen only a small uptick in bullish sentiment and a minuscule drop in bearish sentiment. The same thing can be seen in the AAII poll during early 2003. In nine weeks, bullish sentiment exploded from 21.1% to 63%, and bearish sentiment plunged from 57.9% to 19%. Since the peak in bearish sentiment in the AAII poll in July, we have five weeks of subsequent data, but so far, bullish sentiment has only risen to 39.4% and bearish sentiment has only fallen to 37.4%.
We would note that long-term trends in market sentiment follow the long-term trends in the stock market. However, during the latest bull market, the peak in bullish sentiment occurred back in 2003, and since that time, sentiment has traced out series of lower highs and lower lows. While the latest readings in market sentiment might have been correct in calling for the recent intermediate-term low, we do not believe that the final market low has been put in, because the longer-term trend in market sentiment is still heading lower. With seasonal factors turning bearish and a typical four-year market low likely later this year, we believe we have to see one more washout in sentiment before the major long-term market trend can turn higher.