Great News: Stocks are Hated

For years, market strategists have tried to explain that investor bullishness is bad for future stock returns, and when investors are very bearish, it’s a great time to buy. They’re right. I’ve gone over 25 years of data compiled by the American Association of Individual Investors (AAII), and found this investing maxim to be remarkably accurate. And guess what? The AAII’s weekly survey has just revealed another low in investor sentiment.

First, let’s take a look at what happened in the late 1980s when investors had just come out of a sharp market crash (the infamous Black Friday of October, 1987) and sentiment was fairly bearish. This table shows the annual low point for investor sentiment from 1987 through 1993 and how the market subsequently fared. Throughout this period, investors were very bearish, and less than one in five investors considered themselves to be bullish. Those lonely bulls sure made some money, though.

Reported Date Bullish Neutral Bearish 1-Mo. Return 6-Mo. Return 1-Year Return 2-Year Return 3-Year Return
12/11/87 23.0% 45.0% 32.0% +3% +9% +18% +48% +40%
07/22/88 16.0% 58.0% 26.0% -1% +9% +30% +34% +45%
03/10/89 13.0% 52.0% 35.0% +3% +18% +17% +28% +40%
11/16/90 12.0% 33.0% 55.0% +5% +19% +19% +35% +46%
01/11/91 22.0% 30.0% 48.0% +17% +22% +33% +39% +51%
09/04/92 14.0% 44.0% 42.0% -3% +8% +11% +12% +37%
07/02/93 18.0% 44.0% 38.0% +1% +5% +1% +25% +47%

If you bought stocks at the annual low point in terms of investor sentiment, your three-year return would have been at least +37% in every one of those years, or roughly +11% on an annualized basis. In some of those periods, annualized returns approached +15%.

#-ad_banner-#In the ensuing years, investor sentiment was never again so bearish (expect for a quick dip in 2003 and 2005). But by 2008, the AAII survey was once again showing bulls to be a lonely group. Investors that chose to wade in while sentiment was very bearish in 2008 surely got burned, as the markets absolutely cratered in subsequent months. So this approach is not foolproof.

But more recently, the strategy has once again been paying off. Fully 70% of investors were bearish at the beginning of March, 2009. Yet, one year later, the S&P 500 was more than +60% higher. Last November, when the bears were once again on the prowl, gutsy investors would have made a decent +6% gain in the next six months.

Reported Date Bullish Neutral Bearish 1-Mo. Return 6-Mo. Return 1-Year Return 2-Year Return
03/13/08 20.4% 20.4% 59.2% +6% -4% -41% -11%
07/10/08 22.2% 22.7% 55.2% +4% -33% -34% -14%
03/05/09 18.9% 10.8% 70.3% +20% +46% +61% N/A
11/05/09 22.2% 22.2% 55.6% +6% +6% N/A N/A
08/26/10 20.7% 29.8% 49.5% ? ? ? ?

This brings us to the latest AAII reading, which shows that bulls are again becoming a lonely crowd, with only one in five investors citing optimism. That’s partially due to a series of weak recent economic reports, but it’s also due to the fact that the S&P 500 is on track for its third straight losing week and has fallen -14% since early May. That’s the main takeaway of this analysis. Investors tend to turn bearish after the market has posted weak returns.

Action to Take –> In times of heightened bearishness, it’s important to separate companies that are truly heading into tough times from companies that are operating at a steady pace but are simply unloved because investors are selling stocks. The latter group is what you want to focus on when making a watch list of stocks to buy.

As a short list of companies that I believe will continue to post decent results, yet are now well off of their highs, you can take a look at:

  • Best Buy (NYSE: BBY)
  • Charles Schwab (Nasdaq: SCHW)
  • American Superconductor (Nasdaq: AMSC)
  • The New York Times Co. (NYSE: NYT)
  • Ford Motor (NYSE: F)

If the market begins to strengthen, these names will likely see fresh buying interest.