What could emotions in the market tell us?

28.06.2023 11:08|Analyst Team, Conotoxia Ltd.

Warren Buffett's famous saying "Be fearful when others are greedy, and be greedy when others are fearful" could be taken as a warning during periods of extreme optimism among investors. Even experienced professionals can sometimes look at reality too optimistically. Excessive expectations could in turn lead to speculative bubbles, which is probably the most opportune time to exit an investment. To assess the accuracy of Buffett's words, let's check the historical data and answer the question of what moment we are currently in.

What is the retail investor sentiment survey?

The Sentiment Survey is a survey conducted by the American Association of Individual Investors (AAII) since 1987. The aim of the exercise is to gauge stock market sentiment. Investors are asked weekly about their expectations for stock market trends in the near term, usually over a six-month period. Respondents are given the option to choose from three responses: bullish (anticipate growth), bearish (anticipate decline) or neutral (no specific forecast).

The data collected is made available for individual use. Sentiment tracking enables investors to gain perspective on future market trends, rather than relying solely on their own expectations or historical macroeconomic data.

The latest survey (dated 21.06.2023) showed that 42.9% of investors surveyed were bullish about the next 12 months, 29.4% were neutral and 27.8% were bearish about the future. Interestingly, these proportions reversed at the beginning of the month. At that time, only 29.1% of investors were optimistic, compared to 36.8% who were negative.

Source: https://www.aaii.com/sentiment-survey

"Be fearful when others are greedy..."

Given that an average of 38% of investors have been optimistic since the beginning of 2000, let us look at situations where this percentage exceeded 50% and 60%, which we could dare to call a kind of euphoria already.

It turns out that when more than half of the respondents declare an optimistic outlook for the next six months, the average change in the S&P 500 index over the next month is 0% (with 57% of profitable positions). The same is true for the next three months, where the average would be 0.6% (with 59% of profitable positions). Similarly, for the six-month period, the average is 0.4% (with 60% of profitable positions).

Source: Conotoxia ltd analysis, AAII data

The attitude of 50% of investors may not yet entitle one to define the phenomenon of widespread 'greed'. However, when more than 60% of those surveyed expect increases, performance does not seem to improve significantly. For the coming month, the average return in such realities is 0.4% (67% profitable positions). An identical result applies to the next three months. What may seem interesting is that the worst average result relates to the four-month period after the reading, amounting to minus 1% (51% of profitable positions). Could we call a strategy with close to 50% performance and zero return correct? It does not seem so.

Source: Conotoxia MT5, US500, Daily

"...be greedy when others are fearful".

Historically, an average of 31% of individual investors expressed pessimistic views. This means that investors are more likely to be optimistic about the future. For this reason, let us look at the periods in which more than 40% or more than half of investors predicted declines in the next six months.

In contrast to periods of extreme optimism, extreme pessimism has historically shown a noticeable correlation. Based on the survey results, when the percentage of bears in the market exceeded 40%, the average return the following month was 1.3% (64% of profitable positions). After three months, the average return increased to 2.2% (65% of profitable positions). For the period of the next six months, this return was already 4.6% (66% of profitable positions) and increased with each extension of the period. We could interpret this to mean that when more than 40% of investors are negative about the future, there is a roughly 65% probability of a reversal of the downtrend in the indices.

Source: Conotoxia ltd analysis, AAII data

When more than half of investors expect indexes to fall, the average gain for the next month was 1.9% (63% of profitable positions). For the period of the next three months, the average result rose gently to 2.3% (56% of profitable positions). For the period of the next six months, the average result rose slightly to 3.3% with the same efficiency. It appears that greater pessimism does not necessarily translate into greater efficiency and return on investment in the S&P 500 index. Despite the higher efficiency of the contrarian approach, it is difficult to take the efficiency of 65% for granted.

What is driving investor emotions and what can we currently expect?

It turns out that the main factor driving investors' emotions is the index performance for the last month. The correlation, as measured by correlation, is 0.36 for the percentage of bulls and minus 0.44 for the percentage of bears. These values could be regarded as a noticeable correlation. This means that the forthcoming investor sentiment reading will largely depend on the recent increases or decreases. With that said, it seems that investors are somewhat more sensitive to possible falls.

At present, we are far from extreme pessimism. Indeed, the highest percentage for the last year was below 50%. However, last September we experienced extreme pessimism, which may set us up for a continuation of the bull market rather than a bear market.

 

Grzegorz Dróżdż, CAI MPW, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 73.18% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

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76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Trading on CFDs is provided by Conotoxia Ltd. (CySEC no.336/17), which has the right to use the Conotoxia trademark.