A Stock Market History Lesson
Going back to Y 1929, the S&P 500, excluding dividends, has been unchanged on the year just 5 times; Y’s 1947, 1948, 1970, 2011, and 2015. Meaning, the success rate of hold a Neutral stance on the market in the 86 years between Y’s 1929 and 2015 is 5.8%.
There are different variations, though, of what it means to have a Neutral outlook of the stock market, they are, as follows:
- It could mean one simply has a market weight position in the 10 economic sectors i.e., they are neither overweight those sectors nor underweight those sectors, yet they are “in the market” and will perform in-line with the market.
- Others might define a neutral stance as being hedged/diversified in such a way that one’s capital is preserved irrespective of the variability of sector performance and,
- Others still might define a Neutral stance as being in cash on the sidelines
Investors are told regularly to take emotion out of their decision making. It is good advice, but it is easier said than done for most individual investors.
Investor sentiment has a significant bearing on decision making and that sentiment changes regularly throughout the course of a year.
We know this thanks to the individual investor survey conducted each week by the American Association of Individual Investors (AAII) that we publish here on LTN weekly each Thursday evening.
The data from that weekly survey represents what direction individual investors feel the stock market will take in the next 6 months, and the latest survey was a real eye opener.
See the survey here: The AAII Sentiment Survey for the Frame Ended 25 May 2016
Keep in mind that sentiment readings are generally regarded as contrarian indicators. So, when Bullish sentiment is low, it is highlighted as a potential positive for the market, especially when it is matched against high levels of Bearish sentiment.
What the latest survey revealed is that only 17.8% of respondents to the survey have a Bullish view of the market over the next 6 months. That is the lowest level of Bullish sentiment since the week of 14 January 2016, and it it is even lower than the 18.9% reading seen the week of 5 March 2009 i.e. at the bottom following the financial crisis. Bearish sentiment hit 70.3% that week and the market bottomed on 9 March 2009.
The long-term average for Bullish sentiment is 38.5%, so the latest reading is definitely a low reading.
The latest reading for Bearish sentiment, meanwhile, is 29.4%. That is below the long-term average of 30.3%. For some added perspective, it is also below the 48.7% reading seen the week of 11 February 2016, when Bullish sentiment stood at 19.2%.
Over the next 10 weeks, the S&P 500 rose 15%.
So, there is low Bullish sentiment right now, yet there is not high Bearish sentiment.
What is really high in here is Neutral sentiment.
Neutral sentiment stands at 52.9%, which is the highest reading since the week of 12 April 1990, and above the long-term average of 31.2%. In fact, Neutral sentiment has not been above the 52% mark since Y 1990.
That elevated level suggests to us that conditions are ripe for a “flat squeeze,” only it is indeterminate if a flat squeeze will be a Bearish or a Bullish development.
Note: a “flat squeeze” is a condition where Neutral investors (on the sidelines) feel compelled to get back into the market.
Many analysts are quick to point to the remarkably low level of Bullish sentiment as an encouraging contrarian indicator that suggests the market is ripe for a “short squeeze.”
It could be, but I am not sold on it because it is not matched with a high level of Bearish sentiment.
The point I am sold on is that there is real potential for a “flat squeeze” that could cut either way for the market.
Looking at the data set from the AAII, which dates back to Y 1987, the most analogous period in our judgment to the sentiment readings seen today was the week of 9 September 1988, when Bullish sentiment was 17%, Neutral sentiment was 52%, and Bearish sentiment was 31%.
The S&P 500 was up 4.2% 4 weeks later.
Neutral sentiment topped 51% the week of 31 December 2015. That was the 1st time it has been above 50% since the week of 7 February 2003. The survey for the last week of December also showed bullish sentiment at 25.07% and Bearish sentiment at 23.62%.
4 weeks later the S&P 500 was down 8.7%.
A lot of individual investors are not expecting any big move for the market over the next 6 months, so if the market starts to get away from them, that could force a squeeze play that exacerbates the directional bias of the move.
Last week the market rallied on Tuesday and Wednesday in a surprise move.
It was surprising in the sense that Tuesday’s big gainer occurred without any headline catalyst.
The rally continued Wednesday with some supportive headlines, those being a bailout deal for Greece and polls showing UK voters may vote to exit the EU.
The biggest catalyst Wednesday, was the market holding its Bullish form following a report that showed new home sales in April hit their highest level since January 2008.
The rally after that strong report delivered a sense of appreciation by the market that the US Fed is going to be raising the fed funds rate soon for the right reasons as opposed to simply raising it to have some additional rate-cut insurance tool for the next downturn.
However, that rally may not have been driven so much by the enthusiasm for an impending rate hike, as it was by the tape itself, which triggered a short/flat squeeze in a week that was expected to be relatively uneventful leading up to the Memorial Day weekend. Trading volume was not heavy, it was below average.
What we do know is that there are a good number of individual investors in Neutral when it comes to their US stock market outlook.
They are keenly aware that the stock market made a huge contrarian move starting in mid-February, and that is why we would argue this week’s gains were really driven by a flat squeeze that led to increased buying interest on the fear that they might miss out on another big rally near term.
If the market starts acting poorly again though the flat squeeze could feed more selling interest.
There is room for a shift in individual investor sentiment.
And that means there is a real squeeze in the making because so many individual investors are taking the middle ground in here.
How they ultimately get squeezed into the action will be very interesting, and the driver of the S&P 500 breaking out to a new all-time high or breaking for a correction to DJIA 16,500 or deeper during the Dog Days of Summer”
Have a terrific Memorial Day weekend.
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