Drop in Investor Optimism Could Spell Trouble

Editors at Investors Intelligence (II) collect more than 100 stock market newsletters and designate them bullish, bearish, or calling for a correction (short-term bearish, but longer term bullish). They publish the outcomes of this newsletter survey on a weekly basis.

Recently, their report showed the biggest weekly drop in optimism we have seen in a long time, after three consecutive weeks of losses for stocks. In the analysis below, I study how stocks tended to perform after newsletters suddenly soured on the market.

Dramatic Drops in Optimism 

Three weeks ago, 57% of newsletters were bullish and just 14.5% bearish according to II, meaning bulls outpaced bears by 42%. The following week, the bulls fell to 46% while the bears jumped to 21.5% -- a 25% difference. The 10% drop in bulls and 17% drop in bulls minus bears were the largest weekly drops since 2018.

The table below summarizes S&P 500 Index (SPX) returns after the percentage of bulls in the II survey fell at least 10% from one week to the next. These signals have not been contrarian. An underperforming market usually follows dramatic drops in the percentage of bullish newsletters.

Six months after these drops, the SPX averaged a loss of roughly 0.5%. One year later, the index averaged a flat return, with less than half of returns positive. This is significant underperformance.

Newsletter sentiment data was much more volatile in the 1970s. The first table above shows 49 drops in bulls of 10% or more, with 42 occurring in the 70s. The table below shows the seven drops since 1980.

Even in the more recent data, poor stock performance followed these 10% shifts lower in bulls. In fact, the SPX averaged a loss three months to a year later after these instances.

In a similar analysis, I looked at the times the weekly bulls minus bears figure fell 17% or more. Stocks underperform going forward, but not as bad as what we saw above. I’m not sure if that’s comforting or not. Six months after these signals, the SPX averaged a gain of 2.16% with 58% of the returns positive. Typically, stocks average a return of 4.35% with 69% of the returns positive.

Again, the overwhelming majority of the signals occurred in the 1970s. The signals since 1980 are below. The SPX performed well the last time we saw this in December of 2018, adding almost 30% over the next year. The signal before was exactly a year from the 2008-2009 financial crisis lows.