Investor pessimism is a positive sign for equity markets

Inflection points in markets usually occur when sentiment reaches an extreme. The times when the consensus is pessimistic and afraid, are most often the best times to invest. Conversely, when the majority of investors are highly optimistic and future prospects seem brightest, risk is often highest. Sir John Templeton may have put it best, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

Today the S&P 500 is only 1% shy of all-time highs and you would expect sentiment to be very positive. Instead, we find a notable lack of optimism. The financial crisis is seven years in the rearview mirror, but the notion that trouble lays ahead still crosses many minds.

For example, since 1987 the American Association of Individual Investors has been asking members if they feel bullish, neutral, or bearish on the markets. The most recent survey results indicated a historically low amount of bulls (only 17.8% of those surveyed). Late last week, Bespoke Investment Group released a study highlighting the historical equity returns at different survey results. As you can see in the graphic below (see Figure 1), when investor pessimism runs as high as it is today, prospective returns in the equity market are quite attractive. Based on the 30 instances when bullish sentiment was similar to today (below 20% highlighted by the red bars), the S&P 500 was up an average 19.97% one year later.

Several other indicators of market sentiment show a similar lack of optimism:

  • Gallop runs an annual survey of adults asking them if they have any money invested in the stock market right now. The current percentage stands at 52%, a 16 year low.
  • The Investor Intelligence Bull Bear Ratio sits at 1.48, not an extreme but below the long term average of 2.0.
  • Also, according to Investors Intelligence, only 39% of investment newsletter writers are bullish. This series saw a low of only 24% in February but 39% is well below historic periods of excess optimism.
  • Moving away from survey data, investor positioning suggests sentiment is complacent at best and outright bearish at worst:
  • Domestic equity mutual funds have seen investor outflows in 17 of the last 29 months, a combined outflow of $34B in the last two and a half years (see Figure 2 below). Recently this pattern has been notably persistent with seven straight weeks of outflows. The Investment Company Institute’s data suggests that in aggregate, no new money has entered the US equity market in the last seven years! Considering the S&P is up three fold since the March 2009 low, we find this remarkable.
  • According to work published by Bank of America/Merrill Lynch, the average percentage of cash held by mutual funds stands at 5.5%, near 15 year highs and barely budging from the 5.6% highs seen at the February 2016 market low.

We are always on the lookout for conditions of increased market risk. While many investors have vivid memories of the trouble behind and continue to expect trouble ahead, sentiment currently remains on the side of the rational and long term investor. There will always be short term risks that grab attention and shake investor confidence. As these scary headlines are digested, markets tend to “climb a wall of worry”. Today that list of concerns might include Brexit, the upcoming U.S. Presidential election, and corporate earnings quality to name a few. But if the risk of extreme optimism and euphoria are present today, we just don’t see it. We continue to suggest “staying the course” with individual allocation targets to high quality equities.

Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.

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