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Investor Sentiment Still Depressed by the Wall of Worry

| May 18, 2023

Investor Sentiment Still Depressed by the Wall of Worry

Thursday, May 18, 2023

The latest weekly data from the American Association of Individual Investors (AAII) showed individual investor sentiment is still at depressed levels. This is perhaps not surprising as investors have built up a “wall of worry” from concerns about lingering inflation, uncertainty over the path of interest rates, recent bank failures, recession fears, and depressed consumer sentiment, not to mention concerns over the debt ceiling and the potential for a U.S. debt default and/or credit downgrade.

The percentage of individual investors who are bullish about short-term market expectations is 23%, down from 29% last week. This marks the lowest level since the end of March and is well below the long-term average of 34%. The percentage of investors who are bearish slightly decreased week-on-week to 40% but was still well above the long-term average of 32%. This puts the spread between the bulls and the bears at -17%, versus a long-term average of +2%.

As shown in chart the below, investor sentiment, as measured by the spread between bulls and bears in the AAII data, is more than one standard deviation below its long-term average. The January rally in the S&P 500 brought some bulls back, with the bull-bear spread getting above zero for a single week, but since then investor sentiment has fallen despite stocks recovering in March and mostly trading sideways since then.

View enlarged chart

While the concerns that are feeding into the individual investors’ “wall of worry” are valid, the negative sentiment they have built up is, from a contrarian perspective, a potential catalyst for positive forward returns.  Stock markets are forward looking and if concerns are well known and understood they are also probably largely priced in. Markets typically slump due to surprises and shocks, not known risks. As such, we view the negative sentiment in the AAII data as a contrarian indicator, suggesting support for stocks, as many potential buyers wait in the wings for current worries to subside. Extremes in pessimism in the AAII data are, on average, bullish for near-term stock market returns (and extreme investor optimism tends to be bearish for the near-term outlook). When the bull-bear spread is around where it is now (between 1 and 2 standard deviations below average), we have seen the strongest S&P 500 returns three months and 12 months out, and the second strongest returns six months out.

View enlarged chart

Summary

There are many risks out there for markets and the economy that have justifiably built up a significant “wall of worry,” but one remaining asset for stocks, from a contrarian perspective, is all this negative sentiment and positioning. We still maintain a modest overweight to equities funded from cash (where the return profiles of short-term products are very attractive, but reinvestment risk has also risen), as equities may still benefit from falling inflation and the potential end to Federal Reserve rate hikes. We recommend a neutral allocation to fixed income, as valuations have become more attractive relative to equities amid higher interest rates.

 

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All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

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