AAII Sentiment Suggests Near-Term Caution

My approach to markets are mostly about understanding the probabilities of upside returns versus downside risks. In this regard, 2020 provides clarity with the benefit of hindsight. In a recession like we have experienced, this would be the first one since records began, where we did not see multiple waves of selling in equities. So when we talk probability, it not certainty.

One indicator I’ve used for a few decades is a measure of individual investor sentiment readings. The  American Association of Individual Investors publishes a weekly report that you can track at home. I take the difference between investors that say they are bullish (assumption is they are already long) and those that say they are bearish (assumption they have lots of cash on hand) to get a net bullish reading. The degree of neutral is important as well.

AAII Bulls-Bears (Z-Score) vs. VTI Total US Market ETF

According to AAII, the historical average of Bulls is 38%, 30.5% for bears for a net 7.5%. The current reading is 18%. Last week that net reading was +31% Bull. The last time we saw such an extreme was in the weeks following the Trump tax cuts in early 2018. Statistically, the Z-Score tells us how many standard deviations away from average the current reading is so that we can compare current readings to statistical extremes. Over the past 5 years, an overbought reading suggests some caution with equities on average are down 57% of the time over the next 3 months about with an average decline in the 4% range. Nothing to panic about to be sure, but it does suggest some caution chasing the market higher at this point. As with most sentiment readings, they tend to be better finding oversold readings and bottoms versus tops.

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