Over the last few turbulent months, we have highlighted a few individual sentiment indicators as they reached extreme bearish levels at one point or another. However, what was exceptional about last week is that a large number of these sentiment indicators all reached extreme bearish levels at the same time. To measure this, we created a sentiment composite based on the five indicators shown in the table below. The sentiment composite measures how many of these five indicators are hitting extreme bearish levels (defined as the most extreme 10% of historical observations) at any point in time, ranging from 0 to 5 out of 5.
| Sentiment Indicator | Extreme Bearish Threshold | |
|---|---|---|
| VIX Index | > | 29.5 |
| Put/Call Ratio | > | 1.0 |
| AAII Bull – Bear Survey | < | -14.4 |
| NYSE Stocks Above Their 200-Day Moving Average | < | 27% |
| NYSE Stock Making New 52-Week Highs – Lows | < | -97.0 |
The historical readings of such sentiment composite are shown in blue in the chart below, alongside the S&P 500 index in orange. The sentiment composite hit 5 out of 5 last week, first on Tuesday and then again on Thursday. Readings of 5 out of 5 have been exceptionally rare, occurring only about 0.5% of the time since 1994, and they tend to coincide with major lows in stocks. More importantly, they tend to precede violent rebounds. As the table below shows, following readings of 5 out of 5 of the sentiment composite, forward S&P 500 returns have historically averaged over 5% one month out and over 28% one year out. Returns have been significantly above average even following a reading of 3 and 4 on the sentiment composite, which have also been fairly rare historically.
The bottom line is that it is usually a bad idea to sell stocks when sentiment is extremely bearish, which is when things look the scariest.
Sauro Locatelli CFA, FRM™, SCR™
Director of Quantitative Research
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