As many of you know, I am fascinated as to why people make the choices and decisions they make. Many people who work in our industry are focused on valuation ratios, dividends, profitability ratios, balance sheets and charts. With data becoming so easily and readily available these days, I think the extra “edge” these data points produce is becoming smaller and smaller. I believe one area of investing that remains important and useful is sentiment. Digging a little deeper, one can find some interesting cross-currents between expected returns and investor sentiment.
What exactly is investor sentiment? In the most basic sense, investor sentiment is how investors feel about the overall direction of the markets or a particular stock.
One way in which investor sentiment is measured is through the AAII Sentiment Survey. This is a widely cited survey and AAII stands for the American Association of Individual Investors. This association is made up of roughly 150,000 investors, with the average member being in their mid-60s with a median portfolio over $1M. Every week, the AAII surveys about 300 members asking them if they feel bullish, neutral or bearish about the direction of the stock market for the next 6 months.
This may not make sense on the surface but when investor sentiment is very bearish or if there is a lack of bullishness, the expected returns of the stock market in the next 6 and 12 months are positive. Conversely, returns are much smaller when investor sentiment is very bullish. If many investors are negative about the stock market, there usually is only one way to go from there. Another interesting anecdote is that the all-time high for investor bullishness was measured at 75% on January 6th, 2000 (months before the internet bubble burst) and the all-time high for investor bearishness was measured at 70% on March 5th, 2009 one day before the S&P 500 reached its bottom in the Great Recession. So often, investors buy high and sell low. They usually overvalue what they already own (the endowment effect) and discount what they don’t own. I remember receiving numerous questions from clients and friends about Bitcoin in November and December, which coincided with the current top in this cryptocurrency. While this isn’t a perfect timing tool, knowing how investors feel about the stock market can give you a decent indication of the kind of future returns to expect.
There are a couple of mutual funds that put these ideas into a process by observing stocks that go through “conditioning periods” or times where the stock price declines due to fundamental or market-related concerns. For example, many grocery and food-related stocks fell in price after Amazon acquired Whole Foods last June. Investors were worried about the impact Amazon’s presence in this space would have. Many of these stocks fell 10, 20 and even 30%. What these funds look for are stocks that stop going down on bad news (expected earnings/sales aren’t as good or an analyst downgrades the stock) and or insiders (executives and board members) buying their own company stock on the open market. Typically, when you see either of these events take place, it is a signal to the market that maybe there has been too much of a negative overreaction in the stock price. This can be a good opportunity for investors to buy companies that probably have the majority of the “bad news” priced into the stock and increase the probability of higher than expected returns. Sometimes the best opportunities are when you have a chance to go against the crowd. The long-term performance of one of these funds is among the best in its category.
Investing is both an art and a science and it’s good to have a balance of both. I think studying behavioral biases and mistakes is more of an art form since it is difficult to quantify in raw numbers. It is important to remember that this does not guarantee success and is not the tell-all indicator. It is just one of the many inputs we use when evaluating stocks and sectors. Human beings are imperfect, prone to mistakes and can be irrational at times which means investor sentiment can stay bullish or bearish for long periods of time. I harken back to a quote from famed economist John Maynard Keynes, “The market can remain irrational longer than you can remain solvent.”