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A Sentiment Poll's Too Optimistic
By Andy Stout (astout@sir-inc.com)
1/30/2003 2:58 PM ET

When investor sentiment becomes more optimistic, the market usually doesn't respond well. The new Investors Intelligence poll came out yesterday, with the bullish percentage at 50 and the bearish percentage at 26.1. The percentage of those polled who think a market correction will occur is 23.9. This marks the third consecutive week that the percentage of bulls came in exactly at 50 despite the S&P 500 Index (SPX – 850.65) falling from 927.57 on January 9 to 854.36 at yesterday's close. Given the current market environment, this seems to be too optimistic. Such misplaced optimism has been a source of pain during this bear market, since excessive bullishness means that most of the buying has already occurred and the risk of a negative surprise is high.

Comparing the percentage of bulls relative to bears is a good indicator of investor sentiment. This is calculated by dividing the bullish percentage by the combined percentages of the two. For this week's reading, that translates to 65.7 percent. As it turns out, the 65 percent area has proven to be a very significant level in the past.

Since the current bear market began in early 2000, there have been only seven instances where this measurement has hit 65 percent (see the chart below). These seven occurrences only include the first cross above 65 and not the subsequent weeks spent at 65 or higher. The 65 percent mark is a definite sign of excessive optimism because once the ratio hits 65, crucial market downturns have followed in the past. (Note: the green line shows the SPX and the blue line shows Investors Intelligence).



A closer look at the data helps further illustrate this point:



All of the time intervals shown above have generated negative returns following these seven occurrences. For the 5-, 10-, and 20-day returns, an amazing five of the seven have been negative. Likewise, all of the signals for the 60-day (or 3-month) returns have been less than zero. You may think this isn't significant because the at-any-time (or average) returns during these time periods are also negative. However, the calculated standard deviations indicate a 60-, 60-, 81-, and 78-percent chance that the signal returns will be less than the average negative returns for the 5-, 10-, 20-, and 60-day returns, respectively.

The optimism we're seeing right now is a sign that investors are going against the trend and attempting to "call the bottom." Doing this has exhausted their buying power and drained any potential sideline money. As shown above, this optimism has historically led to market declines during the current slump. As long as investors continue to display unwarranted optimism this market will remain extremely vulnerable.

- Andy Stout (astout@sir-inc.com)