Is Investor Sentiment A Valuable Contrarian Indicator?

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From Seeking Alpha

The American Association of Individual Investors (AAII) Investor Sentiment Survey for the week ending January 12 showed that 52.3% of investors are bullish. Only 23.4% are bearish. The rest are neutral.

The bears proclaim this is a very negative signal. Here’s why…

The association releases the results of its Internet survey – which asks members to register their bullish, bearish, or neutral views on the stock market – early each Thursday. (You can visit the site at http://www.aaii.com/sentimentsurvey).

Over the past two decades, it’s sometimes proved a valuable contrarian indicator. If the reading is overly bearish, for instance, it’s often a sign that the market will rally. For example…

    * On March 5, 2009, the AAII survey registered its lowest bullish reading in 17 years. Days later, the Dow embarked on a 14-month bull run that has sent it up nearly 90%.
    * And in October 2007, bullishness hit 62%, just as the S&P 500 was peaking at its all-time high.

Clearly, investor sentiment is a good contrarian indicator. But is the AAII survey really such a powerful signal? Hardly…

Two Problems With the AAII Survey

The indicator gives false signals again and again.

Historically, the market has rallied long after measuring a high level of bullish sentiment – and continued to fall after the majority turned bearish.

There are two reasons for this:

    * The Survey Size: The AAII’s survey sample size is typically so small and its methodology so fraught with holes that it’s statistically worthless. Only 200 to 300 investors respond each week – less than 0.2% of the association’s 150,000 dues-paying members. And the respondents aren’t random, but rather, only those who choose to volunteer.

David Madigan, professor and head of the Department of Statistics at Columbia University, says that from a strict, statistical perspective, the AAII survey is “pretty much useless.”

    * Investor Sentiment: The second reason that this indicator isn’t all it’s cracked up to be is that historically, investor sentiment is right most of the time, not wrong. What the bears fail to understand is that average investors are trend followers. And trends tend to last a long time.

The problem, however, is that these investors rarely change their minds about the direction of stocks until the market forces them to. They’re right the majority of the time, but wrong at both extremes. They get caught buying at the top and selling at the bottom. That’s why this indicator is of some value when it hits extraordinary levels.

But we’re not there yet…

This doesn’t mean the market will continue to power higher, of course. Stock market investors have to live with the reality that markets can turn on a dime… and for reasons that virtually no one was expecting. That’s life.

But the AAII survey hasn’t reached troublesome levels yet. And that means the bears may experience more pain and agony before this bull market ends.

By Investment U

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