Bearish Sentiment Surges As If The Market Just Crashed
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Investor’s bearish sentiment has surged to levels that generally align with previous market corrections and crashes. While concerns about the recent market correction have risen, and bearish headlines are rampant, investor sentiment has become so bearish that it’s bullish.
While that may be hard to fathom, negative sentiment occurs near market lows from a contrarian investing view. S&P’s Sam Stovall once said, “When everyone is bullish, who is left to buy?” The opposite is also true.
One of the hardest things to do is go “against” the prevailing bias regarding investing. As Howard Marks once stated:
“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while.
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”
Currently, everyone is bearish. Of course, this is unsurprising, given the recent media headlines panicking over the decline. Yes, stocks are down in February, but no one worried about stocks hitting all-time highs earlier in the month. But that is always the case when asset prices are rising. However, if investing aims to “sell high and buy low,” then corrections are something investors should look forward to.
“In good times skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.
The things that terrify other people will probably terrify you too, but to be successful an investor has to be stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.“ – Howard Marks
Given that investors historically always do the opposite of what they should by “buying high and selling low,” a contrarian will look to take advantage of those mistakes. Emotions drive most investors’ buying and selling decisions. Therefore, when retail investors’ bearish sentiment rises to high levels, from a contrarian view, this is precisely the time you want to be a buyer.
But that is always a difficult thing to do.
Everybody is bearish—not just in terms of “investor bearish sentiment” but also in “positioning.” In last week’s Daily Market Commentary, we noted the rising level of bearishness.
“The American Association of Individual Investors (AAII) sentiment indicator claims that 60.6% of retail investors are bearish. The percentage of bears in its survey increased sharply from 40.5% in the prior reading on February 19. The AAII retail investor survey is now the most bearish it has been since September 2022. More stunning, this is only the sixth time since 1987 that bearish sentiment has been above 60%. Furthermore, the five-week change in the index is the third largest in history.”
The graph below shows that a similarly high level of retail investor bearishness occurs most often when the market has already declined significantly. Some may argue that political sentiment may dramatically impact the current reading, as seen in other surveys. However, the jump in bearishness occurred over the past week, not when Donald Trump became President.
Let’s begin with some analysis from Sentimentrader. In its analysis, the other five times bearishness was above 60%, the average return six months later was +14.26%, and increasing to 22.35% over the next 12 months. The S&P 500 was up six months later in four of the five instances. Moreover, the market posted positive returns in all instances over the full year.
What is interesting about the data is that retail investor bearish sentiment is at levels that have normally aligned with more severe market corrections like the Financial Crisis and the Pandemic in 2020. Yet, as shown, the recent correction is only about a 3% decline, yet bullish sentiment has plunged as if the market just crashed.
However, it is not just retail investors who are suffering. Our composite index of both professional and retail investors shows a similar decline. Sentiment among the majority of investors has, again, reached levels more associated with significant market corrections and market bottoms, as identified by the blue-shaded areas.
If we convert that composite sentiment score into a Z-score, sentiment is approaching two standard deviations below its average level. As noted, such levels are more coincident with market bottoms than the beginning of a corrective cycle.
The lesson is that headlines drive sentiment, and when sentiment becomes too negative, as may be the case today, such allows for rallies to form. Does this mean the next major bull market rally is set to begin? No. But it does suggest that there are such high levels of negative sentiment that selling today will likely be a mistake.
The biggest problems for individuals are the “herding effect” and “loss aversion.” Notably, “loss aversion” is one of the leading factors influencing investment decisions, according to a survey from the CFA Institute.
“Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.” – Corporate Finance Institute
Unsurprisingly, investor psychology is one of the most significant reasons individuals consistently fail to achieve their investment goals. Our behavioral traits plague our investment decision-making.
George Dvorsky once wrote that:
“The human brain is capable of 1016 processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“
In other words:
“The most dangerous element to our success as investors…is ourselves.”
As noted, when markets decline, investors try to avoid further losses by selling positions. However, when we combine the current levels of extreme negative sentiment with the market’s technical condition, the potential for a reflexive rally increases. The chart below shows that when the Relative Strength Index (RSI) is near 30, and overall market breadth is increasing, this has usually marked the low of a near-term decline.
That negative divergence of improving breadth, against a backdrop of bearish sentiment, fuels a rally. As the market rises, investors reverse bearish positioning to regain equity exposure. That reversal of positioning causes prices to rise further, requiring increased equity purchases.
Unfortunately, retail investors tend to chase the market to the next peak and then repeat the process.
You can do better.
As a contrarian investor, excesses get built when everyone is on the same side of the trade. When the shift in sentiment occurs, everyone is so bearish that the probability of a reflexive market rally increases markedly.
Therefore, to navigate markets over longer-term time frames, we must:
While it is easy to get tied up in the daily news headlines, investing requires assessing the probabilities of future outcomes.
Nonetheless, we can not deny that we are currently in very uncertain markets, which makes investing increasingly tricky. Valuations across all asset classes are elevated. There is an unknown risk to policies being implemented by the current Administration. The economy is slowing and excess savings for consumers are running dry. Add to that elevated interest rates, sticky inflation, and uncertain monetary policy, the risks are quite evident.
However, there are some steps to take when investing in uncertain markets to weather the increased market volatility.
Furthermore, during periods of uncertainty, focus on probabilities rather than possibilities and look for companies that:
Investing is never easy.
This is why a well-thought-out strategy, a longer-term timeline, and the ability to stick to discipline can help you reach your goals.
The takeaway from this commentary is not to let bearish sentiment and media headlines drive the decision-making process in your portfolio strategy. The market will likely rally over the next few days or weeks. We suggest using that rally to rebalance your portfolio, reduce excess risks, and position for a more volatile market this year.
Focus on managing your portfolio and leave being “bullish or bearish” to the media.
For more in-depth analysis and actionable investment strategies, visit RealInvestmentAdvice.com. Stay ahead of the markets with expert insights tailored to help you achieve your financial goals.
Everybody Is Bearish
The Psychology Of Loss Avoidance
Don’t Let Emotions Control Your Investing
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Be Very Greedy When Others Are Very Fearful
Taking Market Volatility in Stride
After a turbulent trading session, equities rallied into the close as February ended, with the widely followed Dow Jones Industrial Average soaring 601 points, or 1.39%, on the final day of the month.
Of course, one might have expected the day to have ended deeply in the red, given breaking news like, “Talks between President Donald Trump and his Ukrainian counterpart Volodymyr Zelenskyy regarding rare earth minerals collapsed.”
And this headline might not have inspired enthusiasm toward equities: “The U.S. economy is setting up to take a major step back in the first quarter after a pair of reports showed weaker consumer spending and a dramatic widening of the trade deficit at the start of the year, according to the Federal Reserve Bank of Atlanta’s latest GDPNow forecast.”
No doubt, it is hard to figure out why stocks do what they do in the short run, and investing has always been an emotional ride. I’ll be the first to admit that it’s easy to get caught up in the daily swings of the market. But as our founder, Al Frank, taught me early on in my investing journey, and after decades in the market, I’ve seen time and again how investors who keep their cool, especially when fear is running rampant, tend to reap the biggest rewards.
I could argue that the big bounce to close out February was because investor sentiment was about as gloomy as I’ve ever seen it. Believe it or not, despite the major market averages still within shouting distance of all-time highs, the latest weekly Sentiment Survey from the American Association of Individual Investors showed only 19.4% of folks on Main Street were bullish. This is well below the historical average of 37.5%, while a staggering 60.6% were bearish, compared to a norm of 31.0%.
Those figures put the bull-bear spread at negative 41.2%, one of the most pessimistic readings on record. History tells us that when sentiment reaches these levels, it’s usually a sign that much better days are ahead.
Investing Digest: Know what’s moving the financial markets and what smart money is buying with Forbes Investing Digest.
AAII Bull-Bear Spread in the Lowest (Most Lucrative) Decile
To be sure, this time (and every time) is different, while past performance is never a guarantee of future returns, but we don’t have to look far to see what happens when the AAII folks freak out. In March 2009, as the financial crisis raged on, the Bull-Bear spread hit negative 51.4%, right at the market bottom. Many thought stocks were finished, but six months later, the Russell 3000 Index was up 52.7%.
In October 1990, when the first Gulf War was providing scary visuals on the evening news, 70.3% of AAII survey participants were bearish. Six months later, the market had surged 40.3%. True, today’s number of Bears is not as great, but across the six other instances where the number of Bears exceeded the current level over the 37-plus year AAII history, the average six-month return has been 19.3%, compared to the “normal” return over that time span of 5.9%.
Time after time, extreme pessimism has set the stage for outsized gains, on average, as evidenced by the 39 previous times where the number of Bulls has been equal to or less than the present tally. True, not every subsequent short-term period was green, but we can’t complain about an average six-month return of 12.2%.
Students of market history will like what the current AAII Bull, Bear and Bull-Bear Spread figures … [+]
Al Frank knew to keep his head when those around him were not. Back in 1979, in the midst of market chaos, he wrote: “I sometimes lose perspective and feel that I am in a battle with almost life and death outcomes. Will the Bull gore the Bear, or will the Bear maul the Bull? Perhaps we should see the market more as populated by chickens, what with all the clucking and squawking at every ruffled feather.” The truth is, most investors react to short-term headlines rather than long-term fundamentals, and in doing so they often miss out on the very best buying opportunities.
Yes, the world is uncertain today, but uncertainty never really goes away, even as it’s natural to feel uneasy when markets are rocky. But I know that fear is often the market’s greatest gift. Al had another saying that I keep in mind during disconcerting times: “They are having a sale in Wall Street, with recently increased discounts. Now is a good time to buy selected common stocks for long-term capital gains in a widely diversified portfolio.”
We will have volatility ahead, but I see no reason to alter my enthusiasm for the long-term prospects of undervalued stocks. Warren Buffett states, “We should be greedy when others are fearful,” and I might argue we should be very greedy when others are very fearful!
For those who like what I have to say in this forum, I suggest taking a look at The Prudent Speculator’s latest Special Report.
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Disclosure: Please note that shares of the stocks mentioned are owned by asset management clients of Kovitz Investment Group Partners, LLC, a SEC registered investment adviser. For a list of stock recommendations like these made in The Prudent Speculator, visit theprudentspeculator.com.
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