We’re naturally sceptical of putting a lot of weight on individual sentiment and positioning indicators, but one of the few we do like is the AAII Bull-Bear spread. It has a long history of data going back to 1987. It is very transparent, being the straightforward result of a weekly survey asking AAII members what direction they feel the stock market will travel over the next six months. And most importantly it has a feature that the vast majority of sentiment indicators don’t have: it has a track record of providing correct market signals.
So when the AAII Bull Bear spread spikes to one of the highest levels on record, we pay attention. The latest survey showed 59.8% of AAII members as bullish and only 15.6% as bearish, the widest spread since 2010 and one that has only been exceeded 35 times (2% of the time) since the start of the survey in 1987.
Historically this has been a pretty good signal of substandard equity returns in the following year. Our analysis shows that when the spread has been between 40% and 50% in the past, the S&P 500 has on average fallen 1.3% over the next twelve months, which is around 0.7 standard deviations below the mean.
On the surface this sounds like excessive bullishness that will soon bring about a correction. However, that would be over-interpreting the signal from the Bull-Bear spread. Neither the AAII indicator, nor most other sentiment indicators have a good track record at predicting returns over a few weeks or months.
A good example of this is the last time the Bull-Bear spread was this high, in December 2010. Initially the S&P 500 rallied another 9% over the next six months, before correcting 19% with the catalyst being a recession scare.
Another takeaway from our analysis is that equities rarely go on big rallies when these sentiment levels have been reached. The S&P 500 was up 10% or more over the next twelve months only 20% of the time, with the norm being closer to 50% of the time.
So the spike in the Bull-Bear spread is the most worrying sentiment sign we have seen in several years. Nevertheless, it does not predict an imminent correction, rather it weighs on expected returns over a one-year time horizon. Bullish sentiment makes markets more vulnerable to something going wrong, but it still takes a catalyst to trigger a correction. In the absence of such a catalyst the fear of missing out remains as strong a driver for equities as it has been.