Bearish Sentiment Surges as If the Market Just Crashed

Investor’s bearish sentiment has surged to levels that generally align with server market corrections and crashes. While concerns about the recent market correction have risen, and bearish headlines are rampant, investor sentiment has become so bearish that it’s bullish.

While that may be hard to fathom, negative sentiment occurs near market lows from a contrarian investing view. S&P’s Sam Stovall once said, “When everyone is bullish, who is left to buy?” The opposite is also true.

One of the hardest things to do is go “against” the prevailing bias regarding investing. As Howard Marks once stated:

“Resisting – and thereby achieving success as a contrarian – isn’t easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, particularly when momentum invariably makes pro-cyclical actions look correct for a while.

Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it’s challenging to be a lonely contrarian.”

Currently, everyone is bearish. Of course, this is unsurprising, given the recent media headlines panicking over the decline. Yes, stocks are down in February, but no one worried about stocks hitting all-time highs earlier in the month. But that is always the case when asset prices are rising. However, if investing aims to “sell high and buy low,” then corrections are something investors should look forward to.

“In good times skepticism means recognizing the things that are too good to be true; that’s something everyone knows. But in bad times, it requires sensing when things are too bad to be true. People have a hard time doing that.

The things that terrify other people will probably terrify you too, but to be successful an investor has to be stalwart. After all, most of the time the world doesn’t end, and if you invest when everyone else thinks it will, you’re apt to get some bargains.“ – Howard Marks

Given that investors historically always do the opposite of what they should by “buying high and selling low,” a contrarian will look to take advantage of those mistakes. Emotions drive most investors’ buying and selling decisions. Therefore, when retail investors’ bearish sentiment rises to high levels, from a contrarian view, this is precisely the time you want to be a buyer.

But that is always a difficult thing to do.

Everybody Is Bearish

Everybody is bearish—not just in terms of “investor bearish sentiment” but also in “positioning.”  In last week’s Daily Market Commentary, we noted the rising level of bearishness.

“The American Association of Individual Investors (AAII) sentiment indicator claims that 60.6% of retail investors are bearish. The percentage of bears in its survey increased sharply from 40.5% in the prior reading on February 19. The AAII retail investor survey is now the most bearish it has been since September 2022. More stunning, this is only the sixth time since 1987 that bearish sentiment has been above 60%. Furthermore, the five-week change in the index is the third largest in history.”

The graph below shows that a similarly high level of retail investor bearishness occurs most often when the market has already declined significantly. Some may argue that political sentiment may dramatically impact the current reading, as seen in other surveys. However, the jump in bearishness occurred over the past week, not when Donald Trump became President.

Let’s begin with some analysis from Sentimentrader. In its analysis, the other five times bearishness was above 60%, the average return six months later was +14.26%, and increasing to 22.35% over the next 12 months. The was up six months later in four of the five instances. Moreover, the market posted positive returns in all instances over the full year..

What is interesting about the data is that retail investor bearish sentiment is at levels that have normally aligned with more severe market corrections like the Financial Crisis and the Pandemic in 2020.

Yet, as shown, the recent correction is only about a 3% decline, yet bullish sentiment has plunged as if the market just crashed.

However, it is not just retail investors who are suffering. Our composite index of both professional and retail investors shows a similar decline.

Sentiment among the majority of investors has, again, reached levels more associated with significant market corrections and market bottoms, as identified by the blue-shaded areas.

If we convert that composite sentiment score into a Z-score, sentiment is approaching two standard deviations below its average level. As noted, such levels are more coincident with market bottoms than the beginning of a corrective cycle.

The Psychology Of Loss Avoidance

The lesson is that headlines drive sentiment, and when sentiment becomes too negative, as may be the case today, such allows for rallies to form. Does this mean the next major bull market rally is set to begin? No. But it does suggest that there are such high levels of negative sentiment that selling today will likely be a mistake.

The biggest problems for individuals are the “herding effect” and “loss aversion.” Notably, “loss aversion” is one of the leading factors influencing investment decisions, according to a survey from the CFA Institute.

“Loss aversion is a tendency in behavioral finance where investors are so fearful of losses that they focus on trying to avoid a loss more so than on making gains. The more one experiences losses, the more likely they are to become prone to loss aversion.” – Corporate Finance Institute

Unsurprisingly, investor psychology is one of the most significant reasons individuals consistently fail to achieve their investment goals. Our behavioral traits plague our investment decision-making.

George Dvorsky once wrote that:

“The human brain is capable of 10¹⁶ processes per second, which makes it far more powerful than any computer currently in existence. But that doesn’t mean our brains don’t have major limitations. The lowly calculator can do math thousands of times better than we can, and our memories are often less than useless — plus, we’re subject to cognitive biases, those annoying glitches in our thinking that cause us to make questionable decisions and reach erroneous conclusions.“

In other words:

“The most dangerous element to our success as investors…is ourselves.”

As noted, when markets decline, investors try to avoid further losses by selling positions. However, when we combine the current levels of extreme negative sentiment with the market’s technical condition, the potential for a reflexive rally increases. The chart below shows that when the Relative Strength Index (RSI) is near 30, and overall market breadth is increasing, this has usually marked the low of a near-term decline.

That negative divergence of improving breadth, against a backdrop of bearish sentiment, fuels a rally. As the market rises, investors reverse bearish positioning to regain equity exposure. That reversal of positioning causes prices to rise further, requiring increased equity purchases.

Unfortunately, retail investors tend to chase the market to the next peak and then repeat the process.

You can do better.

Don’t Let Emotions Control Your Investing

As a contrarian investor, excesses get built when everyone is on the same side of the trade. When the shift in sentiment occurs, everyone is so bearish that the probability of a reflexive market rally increases markedly.

Therefore, to navigate markets over longer-term time frames, we must:

• Avoid investing in events that have a low probability of occurring.
• Don’t try to “trade” markets.
• Reduce leverage and speculative bets.
• Avoid selling quality companies just because they are down.

While it is easy to get tied up in the daily news headlines, investing requires assessing the probabilities of future outcomes.

Nonetheless, we can not deny that we are currently in very uncertain markets, which makes investing increasingly tricky. Valuations across all asset classes are elevated. There is an unknown risk to policies being implemented by the current Administration. The economy is slowing and excess savings for consumers are running dry. Add to that elevated interest rates, sticky inflation, and uncertain monetary policy, the risks are quite evident.

However, there are some steps to take when investing in uncertain markets to weather the increased market volatility.

• Have excess emergency savings so you are not “forced” to sell during a market decline to meet obligations.
• Extend your time horizon to 5-7 years, as short-term stresses can take time to resolve.
• Don’t obsessively check your portfolio.
• Consider tax-loss harvesting (selling stocks at a loss) to offset those losses against future gains.
• Stick to your investing discipline regardless of what happens.

Furthermore, during periods of uncertainty, focus on probabilities rather than possibilities and look for companies that:

• Have consistent earnings growth over time.
• Focus on dividend-payers and avoid high leverage.
• Free cash flow and strong operating margins are essential.
• Avoid companies dependent on consumer spending, have high cash burn rates, or have negative incomes and earnings.
• Invest incrementally using lower prices to build positions.
• Lastly, don’t forget about bonds, a haven in an economic storm.

Investing is never easy.

This is why a well-thought-out strategy, a longer-term timeline, and the ability to stick to discipline can help you reach your goals.

The takeaway from this commentary is not to let bearish sentiment and media headlines drive the decision-making process in your portfolio strategy. The market will likely rally over the next few days or weeks. We suggest using that rally to rebalance your portfolio, reduce excess risks, and position for a more volatile market this year.

Focus on managing your portfolio and leave being “bullish or bearish” to the media.