Beware the Crowds at the Extreme

Folks, the stock market has gyrated up and down over the past seven months…

The S&P 500 Index climbed as high as 4,800 at the start of this year. Then, it plunged to less than 4,200 by early March. And in the end, it’s at roughly the same place today as it was in early September 2021.

As you might imagine, that turbulence has had a dramatic impact on investor sentiment. Not surprisingly, the mood of investors changes a lot depending on when the market is rising or falling.

My mentor and colleague, hedge-fund legend Marty Zweig, called that collective mood “market sentiment” – or just “sentiment.”

That’s a household term these days. But decades ago, Marty was one of the early leaders in measuring this type of market activity…

At Marty’s company, we did a lot of our own polls. We called other professional investors and traders – always the same ones every week. We aimed to produce a measurable record of sentiment.

Marty’s quantitative models also included other “sentiment” indicators – such as the “put-call ratio.” He invented that metric back in the 1960s. It tracks bearish sentiment (put buying) versus bullish sentiment (call buying).

And the saying Marty coined for measuring the sentiment of the market is, “Beware the crowds at the extreme.”

That’s a contrarian view of the market’s mood. But it’s important to understand…

Alongside Marty, I learned that the market will cause the most pain to the greatest number of people. After all, the crowd is what takes a beating when the market makes big moves…

Now, of all the indicators and tools we used to observe the market sentiment, the American Association of Individual Investors (“AAII”) weekly poll of its members was Marty’s favorite. It’s my favorite, too…

The AAII asks, “What direction do you feel the stock market will be in the next six months?” And the nonprofit organization only offers three choices – bullish, neutral, or bearish.

Here’s the data from the past four weeks…

The simplest way to read the data is to subtract the number of bears from bulls. The more bulls, the more positive the crowd is on the market at that time… and vice versa.

You might find it interesting to see the historical averages for this survey, too…

When you compare the two tables, the takeaway is clear… The crowd is afraid right now.

In the AAII’s most recent update, bearish sentiment was roughly 14% higher than the historical average. And in the update before that, it was nearly 20% higher.

But the thing is, for contrarian investors, it’s best to bet the other way at an “extreme”…

We want to go against the “crowds.”

Now, it’s important to note that none of the past four weeks were as extreme as it gets. Notice that the one-year bearish high was nearly 54%. That happened back in February.

It’s a small sample size. But the S&P 500 is up about 4.5% since that extreme.

And even though we’re not at the most extreme levels today, the message is still clear…

Right now, the crowd thinks the market’s future looks bleak.

Bears outnumber bulls by two to one. And that’s in spite of the reality that the market is still down for the year. That’s something that historically precedes renewed upward momentum.

The crowd is clearly afraid today, with the market ready to bounce. So beware the crowds at the extreme. And importantly, be a contrarian when it comes to market sentiment.

Good investing,

Carlton Neel

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