Posted by lplresearch
Monday, January 31, 2022
The latest weekly data from the American Association of Individual Investors (AAII) showed a sharp increase in the percentage of individual investors who are bearish (52.9%) about short-term market expectations, the second most bears of the past 10 years and the highest level since early April 2013. Even though the proportion of investors who are bullish was up slightly from a week ago (21% to 23.1%), the spread between the bulls and the bears fell sharply reaching -29.8%, a rapid decline from the turn of the year when bulls had outnumbered bears.
“As investors reacted to the worst ever start to the year for the S&P 500 the sentiment data is now at bearish levels not seen for the best part of a decade,” explained LPL Financial Quantitative Strategist George Smith. “However when we look at historic data extremes in investor pessimism, such a high number of bears could be a contrarian indicator that’s actually bullish for stocks, at least in the short term”
Contributors to the wall of worry that has turned investors more cautious include the first stock market correction since the 2020 COVID-19 related bear market, the markets adjusting to the prospects of Federal Reserve (Fed) rate hikes and quantitative tightening (QT), heightened inflation expectations, the potential for further global supply chain issues, and increasing geopolitical tension over Russia/Ukraine.
As shown in the LPL Chart of the Day, investor sentiment, as measured by the spread between bulls and bears in the AAII data, has plummeted since the turn of the year. The spread between bulls and bears is also at its lowest level since April 2013 and last week dipped more than two standard deviations below the 10-year rolling average for the first time since the first half of 2020.
However, extremes in negative sentiment tend, on average, to be bullish for future returns in the near term (just as extreme optimism tends to be bearish for stocks). When the AAII Bull-Bear is more than two standard deviations below its long-term average, as it has been for the past two weeks, the average return one year out has been +11%. Caution is still required in interpreting this data as even at very bearish sentiment levels the annual average hides a wide range of returns; -47% to +57% (with these extremes occurring during the great financial crisis downturn and at the 2009 bear market bottom respectively). Since that 2009 bear market bottom when sentiment has become very bearish, as it is now, the average short term returns have been well above the average for the same period (with 3-, 6-, and 12-month returns of 10%, 17% and 32%, respectively compared to averages of 4%, 7% and 14% respectively)
Other sentiment indicators that we monitor, such as expectations for market volatility and the average put/call ratio have also recently been flashing potential contrarian signals. The VIX futures curve has inverted, a sign that near term volatility is not expected to persist, and the put/call option ratio recently reached the highest ratio of puts since March 2020.
While we were certainly expecting, and have already seen, more volatility in 2022 than the “Goldilocks” year we had in 2021 we believe the current extreme levels of investor pessimism may be not warranted. We see a low probability of this correction being the start of cyclical bear market as the economic environment is still strong and, while not zero, the odds of a policy mistake from the Fed appear low. New Omicron cases in the U.S appear to be falling fast (down 20% from the peak) giving us hope that the related hit to supply chains and workforce participation may be approaching its peak. This would be good news for domestic price and wage inflation pressures leading us to believe that inflation could be nearing its peak by the middle of the year, especially as the base effect for year-on-year CPI numbers become more favorable as we move further into 2022.
Risks do remain, like the potential for supply chain issues stemming from Chinese lockdowns to lead to elevated inflation lasting longer than expected, geopolitical risk in relation to Russia/Ukraine escalations, potential for earnings or economic data misses, new COVID-19 variants, and while not our base case, a Fed policy mistake. Mid-term years have also tended to be more volatile than the first year of a presidential term. Given the start to the year we have seen we have no reason to believe 2022 will be any different, but we still believe the economic environment for stocks still looks favorable compared to bonds and cash.
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