When Wall Street’s lemmings all start moving in one direction, it’s smart to run the other way.
The market’s recent weakness caught many bullish investors off guard. And after a few weeks of selling, investors are feeling quite bearish.
According to Bespoke Investment Group’s sentiment composite index, net bullish sentiment hit its lowest level since April of last year!
(By the way, Bespoke Investment Group is a great source of statistical information for investors. I recommend following Bespoke’s Twitter feed.)
Fewer bulls in the market might sound like a bad thing. But historically, investor sentiment has been a contrarian indicator for stocks.
Let’s take a look at what’s happening, and how you can use this statistic to your advantage.
Investor Sentiment as a Contrarian Indicator
When I was at the hedge fund, we had a few clients that were contrarian indicators.
These clients would call when things got really bad — or when things were really good — and offer their opinion.
If Rob was concerned about the market, it probably meant we were pretty close to a bottom. His fear would show up after the market had already sold off. And when Rob was ready to throw in the towel, it meant that the selling was probably over.
Similarly, there were days when Rob would call and chastise us for “not being long enough.” (Or not having enough exposure to the market.) That call usually meant that Rob was extremely optimistic — and that we were about to have a pullback.
Sentiment readings make sense as a contrarian indicator.
Because when the majority of investors are “excessively optimistic,” they naturally have more of their capital committed to the market.
What could cause them to add more to the market?
That’s the problem. When bullish sentiment is high, investors have already committed the maximum amount to stocks. And any surprise will likely cause them to sell.
The opposite is also true.
When bullish sentiment is at an extreme low, it means investors have already pulled money out of the market. And from this point, any positive news could trigger a wave of buy orders.
Watching sentiment readings can give you a good idea of which way the market is most likely to be surprised.
Good News Heading Into Earnings Season
This week marks the unofficial start to earnings season. And this earnings season is especially important because of where things stand with the economy.
After a breathtaking rebound from the coronavirus crisis lows, investors are now in a state of limbo.
- Will the economy continue to expand?
- Is the government set to provide more stimulus?
- Are higher interest rates hurting the recovery?
- Will supply chain challenges crimp profits?
- Is inflation transitory or will it continue?
Believe it or not, that state of limbo — and the concerns investors have about our economy — works to our favor.
The chart below shows the percentage of investors who consider themselves to be “bearish.” This level has been exceptionally high for the last few weeks and is starting to turn the other way.
I love heading into earnings season with a high level of bearishness. Investors have light exposure to the stock market. So there is plenty of room for them to buy shares when companies announce positive results.
Perhaps more important than the earnings results will be the guidance executives offer.
Management teams may tell investors that supply chain issues are being worked out… They may mention that profits should be strong heading into the end of the year… Or that costs are under control…
When that happens, investors will react positively!
Now, not all stocks will have the same response to earnings announcements.
Remember, we want to avoid the stock market (investing in an index that doesn’t do a good job of diversifying your exposure).
Companies who beat Wall Street’s low expectations have a strong probability of trading higher. And as a whole, the market is primed to react well to positive surprises.