Investor sentiment can serve as a useful indicator of future market returns. In general, when investors are overly optimistic, returns are below average 12 months out. When investors are overly pessimistic, returns are above average 12 months out. This is one reason for the ole’ Warren Buffet adage: “Be fearful when others are greedy and greedy when others are fearful.” The latest and most famous application of this quote would have been in March 2020 during the depths of the Covid Crash. The S&P 500 had just fallen 35% in five weeks. Few could have imagined it at the time, but it was definitely wise to have been greedy at that time, (i.e. buy as much as you can), while everyone was very scared about the economy and stock market. While sentiment isn’t an end all be all for projecting future returns, it’s certainly something to be mindful of.
The Ned Davis Research crowd sentiment poll
There are many different ways to gauge investor sentiment, but one of our favorites is the Ned Davis Research Crowd Sentiment poll. This poll looks at a number of different categories, such as investor surveys and money movement in the market (are people piling into bullish or bearish funds, for instance). The poll then aggregates these data points into ratios and forms a composite index. We can see the latest results below:
As you can see, the poll crashed to lows with the market as Covid unfolded and then spent much of 2020 in neutral territory. However, as 2021 progressed, this indicator of investor sentiment has moved into extreme optimism territory. More recently, it fell back into neutral. While not a perfect timing indicator (nothing is), prior “extreme optimism” readings in 2018 & 2020 did precede pullbacks of 14%, 19%, and 35% in the S&P 500, as shown below:
To reiterate though, these pullbacks didn’t occur the second the indicator crossed into extreme optimism territory. But the readings did a good job flagging potential bumps in the road that were soon to come.
What should we expect now?
The Ned Davis Research Crowd Sentiment poll recently crossed back under the extreme optimism level and is back in neutral territory. When this has happened in the past it has preceded some material weakness in the S&P 500 within the next 6-12 months. Importantly, none of that weakness stopped the market from continuing on a long-term trend overall.
By being aware of sentiment indicators like these, and the possible ramifications, it can be easier to stomach stock market volatility when it does show up. When we’re on the look out for potential volatility, it doesn’t catch us off guard, and we become less likely to make bad decisions in the face of that volatility.
All in all, understand that evaluating investor sentiment is just one way to try and build expectations for the market moving forward. The goal of our evaluation isn’t to make a call on the market. Rather, it’s to help us stay mentally prepared so that we aren’t surprised by what the market does next.