AAII Investor Sentiment as a Stock Market Indicator
June 25, 2014 • Posted in Sentiment Indicators
Is the conventional wisdom that aggregate retail investor sentiment is a contrary indicator of future stock market returns accurate? To investigate, we examine the sentiment expressed by members of the American Association of Individual Investors (AAII) via a weekly survey of members. This survey “measures the percentage of individual investors who are bullish, bearish, and neutral on the stock market for the next six months; individuals are polled from the ranks of the AAII membership on a weekly basis. Only one vote per member is accepted in each weekly voting period.” Survey results are apparently available the market day after the polling period. We define aggregate (net) investor sentiment as percent bullish minus percent bearish. Using outputs of the weekly AAII surveys and prior-day closes of the S&P 500 Index from July 1987 through May 2014 (1,400 surveys and almost 55 independent 6-month forecast intervals), we find that:
Two weekly survey reports are missing, one in January 1996 and one in June 2000. One weekly level of the S&P 500 Index is missing in September 2001. We ignore calculations affected by these missing data.
The following chart shows net investor sentiment and contemporaneous S&P 500 Index level over the available sample period. Visual inspection suggests that individual investors are usually bullish in aggregate and that sentiment may move with the stock market. The average net investor sentiment is 8.4%.
For precision, we relate net investor sentiment to future stock market return.
The next chart summarizes Pearson correlations between net investor sentiment and S&P 500 Index returns over various past and future intervals, using the stock market close on the day before publication of survey results to separate past and future returns (as the last close that could influence poll participants). Since polling takes place over a week, 1-week and 2-week past returns are most immediate for survey participants. Results suggest that:
- Sentiment relates positively to recent lagged returns. In other words, an advancing (declining) stock market indicates relatively high (low) net investor sentiment.
- Sentiment relates negatively (but weakly) to future returns over short to intermediate horizons. At the surveyed horizon of six months, the correlation between net investor sentiment and future return is -0.12. The R-squared statistic is therefore about 0.01, indicating that sentiment explains just 1% of the variability in returns.
It may be that the contrarian stance of polled investors represents their failure to anticipate some mean reversion tendency of recent stock market returns. In other words, aggregate sentiment is a proxy for market mean reversion. See “Purifying Stock Market Sentiment Indicators” for elaboration of this interpretation.
For the the weekly survey/report frequency, return measurements for intervals longer than one week overlap. These overlaps can distort statistics (and mean that an investor could not fully exploit all signals).
Is the contrarian relationship with future return stable over time?
The next chart shows rolling lagged 52-week Pearson correlations between between net investor sentiment and S&P 500 Index 26-week future return over the available sample period. The correlations are mostly negative (individual investors in aggregate usually lean the wrong way) but are occasionally positive. The upward sloping dashed trend line suggests that investors have improved their understanding of stock market mean reversion over the sample period.
As a separate test of trend, the correlation between net investor sentiment and S&P 500 Index 26-week future return is -0.25 (-0.06) over the first (second) half of the sample period. The break point between the first and second halves is about the end of 2000. In other words, individual investors lean less the wrong way after 2000 than before.
What drives the contrarian indication?
The final chart summarizes the average 1-week and 26-week S&P 500 Index future returns by ranked tenth (decile) of net investor sentiment measurements over the available sample period. Results suggest that:
- For 1-week future return, there is no reliable relationship with sentiment.
- For 26-week future return, the relationship with sentiment derives from extreme deciles 1, 9 and 10. Sentiments in deciles 2 through 8 are uninformative.
- Even the most extreme bullish decile does not indicate shorting.
The threshold of net investor sentiment for the most bearish (bullish) decile is < -15% (> 32%). Returns in the most bearish decile exhibit high variability compared to other deciles.
Considering even more extreme net sentiment distribution tails:
- The average 26-week S&P 500 Index return after the 1% most bearish net sentiment readings (14 observations < -35%) is about 15%. However, many of these 14 observations occur close together, supporting only six independent trades in 27+ years.
- The average 26-week S&P 500 Index return after the 1% most bullish net sentiment readings (14 observations > 49%) is about -2.1%. Again, many of these 14 observations occur close together, supporting only eight independent trades in 27+ years.
In summary, evidence indicates that investors may be able to exploit extreme values of AAII net investor sentiment as contrarian signals, but reliable (extremely bearish sentiment) signals are rare.
Cautions regarding findings include:
- The above analyses are in-sample. An investor operating in real time during the sample period would have only past data to estimate any net sentiment thresholds for signals.
- As noted, overlapping return measurement intervals can distort statistics (or, said otherwise, result in signals that are not fully tradable).
- The cutoff dates for return calculations (closes before report dates) delineate what survey participants may know, but result in future returns that are not fully exploitable by about one trading day.