What You Need To Know
The stock market's recent rally can be traced to classic contrarian indicators signaling a buying opportunity. The AAII bull-bear spread has hit its lowest since late March, historically a sign of an impending market upswing. Goldman Sachs' analysis supports this view: typically when the bull-bear ratio falls below 0.5, the S&P 500 tends to see average increases of 2.6% after one month, 4.3% after three months, and 8.3% after six months.
The trend is further supported by the BofA Bull & Bear Indicator, which reached a low unseen since the previous November, marking a consistent bullish signal over three weeks. The BofA Sell Side Indicator also points to a strong buy, diverging from its previous stance as a sell signal. It now forecasts a 15.5% potential rise in the S&P 500 over the next year. Despite the current negative investor sentiment, these indicators collectively hint at a positive trajectory for the stock market looking ahead.
Contrarian investing involves taking positions against prevailing market trends on the belief that the crowd is wrong.
Why This Is Important for Retail Investors
Opportunity for Entry: Retail investors often look for optimal entry points to invest, and the current indicators suggest a potentially advantageous time to buy stocks. The historical data indicating a rise in the S&P 500 following similar sentiment levels could encourage retail investors to enter the market at a point that may offer a favorable return on investment.
Risk Management: Understanding these signals can help retail investors manage their risk better. By recognizing historically contrarian buy signals, they can make more informed decisions that balance their portfolios against market pessimism, potentially safeguarding against the herd mentality that can lead to poor market timing.
Strategic Asset Allocation: Knowledge of these indicators can assist retail investors in adjusting their asset allocations. For example, if they have been overly conservative, understanding these buy signals might prompt a strategic shift to capitalize on potential upcoming growth in equities.
Long-Term Planning: The prediction of a 15.5% increase in the S&P 500 over the next year can be particularly relevant for retail investors with a long-term investment horizon. It may influence their decisions to stick with or adjust their long-term investment strategies.
Confidence in Market Dynamics: Retail investors gain confidence when they understand the market dynamics that professional and institutional investors watch. Knowing that there are data-driven reasons for market optimism, despite prevailing negative sentiment, can empower them to make decisions based on economic indicators rather than emotions.
As a contrarian view, this means going against the consensus view and therefore carries a higher degree of risk.
Being Aware of Investor Sentiment
Investor sentiment, often reflected through surveys like the AAII Sentiment Survey, is a potent contrarian tool in predicting market movements. While immediate sentiment shifts may not offer clear market direction, extreme levels often precede market reversals. When investor sentiment is overly bullish, markets tend to decline, and when sentiment is excessively bearish, markets typically rally.
Historically, the AAII survey, which gauges the mood of individual investors, suggests that the majority opinion rarely aligns with future market performance. For instance, record-high bearish sentiment indicated market bottoms and peak bullish sentiment often signaled forthcoming downturns.
Technical analysis utilizes historical data to establish sentiment extremes based on standard deviations from the mean. Findings confirm that significant market turns often occur when sentiments breach these extremes.
However, while sentiment is a valuable indicator, investors should not solely rely on it but use it alongside other indicators to guide investment decisions. Being aware of sentiment helps investors avoid the pitfalls of herd mentality, which can lead to poor investment outcomes.
Wall Street Veteran Sees Year End Rally
Larry Adam, the chief investment officer at wealth management firm Raymond James' private client group, suggests that the stock market's recent downturn is setting the stage for a comeback. He points out that the S&P 500 has dropped sharply, creating a window for potential growth as we approach year's end and beyond, with a 6% rise to his year-end target of 4,400 and a 12% increase to a 12-month target of 4,650.
Adam highlights five key reasons supporting a market rally:
Fed's Tightening Cycle: Adam believes the Federal Reserve's rate hikes have likely concluded with the one in July, given signs like long-term bond yields doing some of the Fed's tightening work and slowing inflation. If the Fed pauses rate increases, it traditionally benefits stocks, with an average 14% gain in the S&P 500 a year after the final hike.
Lower Interest Rates' Support: With predictions of economic slowdown and disinflation, Adam expects Treasury yields to drop, which historically favors stock market growth.
Strong Earnings Underappreciated: Despite the end of an earnings recession and significant growth in earnings per share (EPS) for large tech companies, the market hasn't fully acknowledged this strength, which Adam sees as a positive sign.
Seasonal Trends: Historically, market performance improves after mid-October, and with the S&P 500 typically gaining in November and December, the seasonal trends could boost stocks further.
Bearish Sentiment as a Bullish Indicator: High bearish sentiment, as measured by surveys like AAII and technical indicators like the RSI, often signals oversold conditions. Adam interprets the current pessimistic sentiment as an optimistic sign for market recovery over the next year.
Adam's perspective is set against a backdrop of Wall Street strategists adjusting their forecasts in response to market movements, with recent cuts reflecting lower targets as stocks have declined. However, despite these downward revisions and last week's turmoil, U.S. stocks have shown resilience, with notable gains in recent trading sessions.
Capitalizing on the Balance Between Fear and Greed
For some investors, the current state of the stock market offers a contrarian buying opportunity, as indicated by the prevailing stock market sentiment. This scenario is where contrarian investors often find their stride, making moves against the grain of general market trends.
In the short term, these investors capitalize on the balance between fear and greed, a concept famously highlighted by Warren Buffett. When the market is driven by fear, contrarian investors see an opportunity to buy, while others are selling. Conversely, when greed dominates the market, leading to overvaluations, they may consider selling.
This approach requires a keen understanding of market dynamics and the ability to remain unswayed by the prevailing sentiment, making calculated decisions based on deeper market analysis and trends.
Read What Others Are Saying
AAII: AAII Sentiment Survey
Morningstar: Here are 5 reasons why U.S. stocks will likely rally into the end of 2023, says one Wall Street veteran