Bullish Sentiment as Contrarian Indicator Explained

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Yesterday, I posted a story about the American Association of Individual Investors' (AAII) market sentiment indicator turned bullish. And when that happens, it often is a contrarian signal, meaning the market may take a dive. I noted that when the AAII surveys its retail (or "civilian" investors, as advisor and snarky blogger Down Town Josh Brown calls them) members and more than 50% of the respondents are bullish, it can spell trouble; conversley, when an overly bearish sentiment prevails, it often signals a market bottom as it did in 2002 and 2003 and in March of 2009. Here are some supporting data on the phenomenon.

This data supporting the contrarian indicator thesis is from the AAII's own website:

This 2004 article provides a good explanation of how the AAII Sentiment Survey can be used as a contrarian indicator. Though some of the numbers have changed since this article's publication, the emphasis on paying attention to extreme readings in sentiment continues to holds true. For example, bearish sentiment reached a record high of 70.3% on March 5, 2009, just as the bear market was reaching a bottom.

The current historical averages are bullish 39% (standard deviation of 10.7 percentage points), neutral 31% (standard deviation of 9 percentage points) and bearish 30% (standard deviation of 10 percentage points). AAII members, on average, continue to be well educated and affluent, though we are proud to provide unbiased investment education for all investors, regardless of portfolio size.

The weekly AAII Investor Update e-newsletter provides updated results for the AAII Sentiment Survey and the monthly AAII Asset Allocation Survey, in addition to valuable investment information. Click here to subscribe.

-Charles Rotblut, CFA

Vice President & AAII Journal Editor

December 2010

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