According to the American Association of Individual Investors (AAII), people are too bullish on the market. The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. We can then peg a ratio to this number, an example would be 2 bullish people for every bearish person results in a bulls to bears ratio of 2:1.
Why is this an important measure to pay attention to? The whole premise is based on potential money not yet in the market, that could propel it higher. Theoretically, if more people are bullish then those people are in the market, which means there isn’t of outside money to push markets higher. Contrastingly, if more people are bearish then there is alot of outside money that could potentially come in to push the markets higher.
The best case scenario if you are invested in the market is for everyone to continue to doubt the markets ability to move higher. Why? Because that represents that many more people who can potentially change their minds and fuel further rallies. Those are the types of sentiment back drops that sparked furious rallies in 2009 and again in the fall of 2010.
The other side of that coin is when people are too bullish even as the market is performing well. This can create a sense of non-fulfillment, like those expect the market to push higher even after monstrous rallies. Those are the types of sentiment back drops that coincided with market tops before the financial crisis in 2008 and the 2011 highs. That is also the same sentiment backdrop we are starting to see now with the market off to its best start to a year in over a decade.
The ratio of bulls to bears has risen above 2.5, the last time the ratio was that high was a short while before the 2011 highs were put in. On the low side, a ratio of 0.5 seems to be the contrarian bullish signal to look for on pullbacks. Around that ratio is where the market bottomed numerous times over the last few years, including in 2008-2009, and 2011.
While nothing is full proof in the market and means this has to happen because of that, one should always be aware of various factors, be it technical, fundamental, or sentimental. The market may very well press higher in the near term, but if it does we’d want to see people become skeptical and get bearish. That would allow the ratio to return to more normal levels between 1.0-1.5. History shows that if we don’t get a downturn in this ratio, it could have bearish implications for the market sooner, rather than later.
The information for this article was derived from the AAII website which can be found here.
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