Opinion – Grain in Grain: Beware of sentiment polls on the stock market

Sentiment research points out that the percentage of individual American investors optimistic about the stock market is the lowest in the last three decades. Data like these scare any reader. However, we need to be very careful with this type of research and what is the best attitude to take with this information.

I get sentiment polls about the stock market almost every month. I don’t shy away from answering, but I take great care to reflect if my answer is the result of what I believe will happen or what I’ve been going through in recent weeks.

The search of American Association of Individuals investors (AAII) is done weekly and measures the percentage of respondents who are optimistic, neutral or pessimistic about the stock market in the next six months. Link to survey (here)

The percentage of bullish investors that was released the day before yesterday of 18.87% is slightly better than last week’s which hit the incredible 15.84% mark.

The chart below shows the evolution of this indicator over time since 1987.

A high frequency can be seen in this graph, which indicates that investors change their minds quickly.

Last November, that is, six months ago, the percentage of investors optimistic about the market reached almost 50%. While the pessimists at that time were only 24% of the total.

As I mentioned, the question investors need to answer is what they believe the market will be in the next six months. If the consensus were right, the market should do well the next semester when there are more bullish investors, and it should do poorly the semester after the percentage of bullish investors drops.

However, this is not quite what happens.

When we measure the correlation of the S&P500’s return over the next six months with the percentage of bullish investors, we find the correlation to be negative (-0.16). Correlation measures the linear relationship between two variables and ranges from -1 to 1.

Negative correlation means that when investors are very optimistic, in the next six months the market tends to go down and when most investors are pessimistic, the market goes up.

For example, look at what happened from last November to today. There was a very large percentage of optimistic investors and the market went down.

In fact, the highest correlation (0.33) of the data is with the return observed in the last two months. That is, the return that the investor has experienced in the last two months is reflected much more in his feeling about what will happen in the future.

So be careful reading sentiment polls about what the consensus believes will happen in the future. They may reflect much more on the recent past.

Some say that these surveys would be a good contrary indicator of what to do, that is, if there are many pessimistic investors, it could be a good time to buy, as the market premium would be high.

The next six months will tell who is right.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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