Economic Strategy: Fear conquers greed

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By Michael Knox

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Chief Economist and Director of Strategy

Date posted:

09 February 2022, 11:00 AM

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Is greed good or is fear better?

One of the most storied indicators of US investment behaviour is the set of sentiment indexes produced by the American Association of Individual Investors. This is a non-profit organisation of some 150,000 members founded in 1978.

For decades, the association has been surveying its members and asking them if they are bullish, bearish or neutral. These numbers are available on the web, together with measures such as the difference between bullish and bearish. Many investment newsletters have discussed them purely in the form that they are published.

Bearish outlook

In this issue, we analyse this data to attempt to extract what information they contain. In Figure 1 below we see the level of bearish sentiment on the last survey of every month since the beginning of 1988. Very interestingly, last month saw one of the most bearish numbers published in that time.

For the last week of January 2022, 52.9% of the members rated themselves as bearish. This was even more bearish than the level in March 2020. Indeed, the current level of bearishness is amongst the highest level surveyed since the late 1980s.

What does that mean?

We examined the level of bullish sentiment and bearish sentiment at the end of each month back to the beginning of 1988. We also examined the relationship between those levels of sentiment and the rate of change of the S&P500 after three months, six months and 12 months. We found that both in the short run and in the long run, the strongest relationship between these measures of sentiment and the rate of change of the S&P500 was after 12 months.

For the long series of data, going back to the beginning of 1988, higher bullish sentiment led to lower rates of change of the S&P500 after 12 months. We also found higher bearish sentiment led to higher rates of change of the S&P500 after 12 months.

Interestingly, the effects were not the same size. The effect of bearish sentiment was much greater on stock market returns than was the effect of bullish sentiment. We found that each 1% increase in the proportion of bullish investors had a negative effect on the S&P500 of 0.15% after one year. The T statistic was 1.5. The chance of this being a random result was 13.3%.

On the other hand, we found that a 1% increase of the proportion of bearish investors had a positive effect on the S&P500 of 0.63% after one year. The T statistic was 5.8. The chance of this being a random result was less than one in 10,000. Importantly, it appears that fear has a greater effect on equity market performance than greed. Fear conquers greed.

Has this effect changed over the years?

We also examine the data again for the period since January 2010. We find again that fear conquers greed. However, the size of the effect has changed. We now find that for the period since January 2010, a 1% increase in the proportion of investors who are bullish, decreases the rate of return of the S&P500 after one year by 0.13%. This time, the T statistic has fallen to 0.9. Bullish investors no longer have a statistically acceptable effect upon stockmarket performance.

On the other hand, a 1% increase in the proportion of investors who are bearish increases the rate of return of the S&P500 after one year by 0.53%. The T statistic is 3.8. The chance of this being a random effect is 2 chances in 10,000. The standard error of this effect is 10.4%. Bearish sentiment explains 18.3% of the rate of change of the S&P500. Since 2010, a model based on the level of negative sentiment at the end of January suggests that the S&P500 will rise by 27% for the year to January 2023. This model, together with the rate of change of the S&P500 since 2010, is shown in Figure 2 above. 

Our examination of this long talked about series, published by the AAII, reveals that it does contain worthwhile information. However, the information works in a different way than usually thought. The effect of bullish sentiment and bearish sentiment upon market performance are very different. Bullish sentiment does have a negative effect on stockmarket performance.

Greed is not good. Still, this effect has a very low level of statistical significance. What is important, both in the long term and in the short term, is the effect of fear on stockmarket performance. High levels of fear (bearish sentiment) very definitely generate high levels of stockmarket performance both in the short term and in the long term.

Conclusion

The high level of fear in the American Retail Investment market as at the end of January 2022 does indicate that performance should be good for the year to January 2023. Still, the model only explains 18.3% of performance. The standard error of the model is 10.4%. 

Talking about stockmarket sentiment, and its effect on the market, is a great story. Still, it looks like examining market fundamentals might still be an even better way of making money out of equities.

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