Where to Next?

I was just checking out Barry Ritholtz's blog The Big Picture, and I came across his post about the AAII Investor Sentinment Survey. The AAII (American Association of Individual Investors) conducts a survey of individual investors and asks whether they are "bullish, bearish, or neutral on the stock market for the next six months." I guess it's interesting to find out that lots and lots of people out there are bearish about the stock market. But my question is: how does this help you make money in the stock market?

Most of these surveys are considered to be contrary indicators - that is, the more bearish people are, (supposedly) the more likely the market is going to bounce pretty soon. The more bullish people are, well, look out below. For what it's worth, I was curious and overlaid a chart of the S&P 500 over the Investors Intelligence Bearish Sentiment survey to see if there was anything to this. It's not the same survey, but it's got a similar idea behind it. Check it out.

(Courtesy of Bespoke Group and Yahoo! Finance)

I guess you might say that when there are big spikes up in the Investors Intelligence Bearish Sentiment Survey, the stock market goes on a little temporary relief rally. But if you bought stocks when this indicator spiked and held on for more than just a couple of weeks, you would be hurting big time.

Other than these tiny little relief rallies that seem to last a couple of weeks, it seems to me that a rising bearish sentiment actually indicates a longer-term trend to the downside. Look at how the bearish sentiment had a pretty upward trend starting in July of 2007 all the way until October or November 2008, and it was just about that point that marked that start of a major decline in the stock market including a complete crash.

Ironically, even as the bearish sentiment started to subside, the market continued to carve out lower and lower depths until March of 2009. After that the bearish sentiment really started to come down in earnest, accompanied by a huge rise in the S&P 500 off its March 2009 lows to new 52-week highs.

So what does this chart tell us? It seems that a big spike in the Bearish Sentiment Survey is a pretty poor time to buy up stocks. It's a pretty bad countertrend indicator except for the occasional schnitzel trade for a couple of weeks.

Rather, the crowd seems to be more right than not. When the Bearish Sentiment starts on an upward trend, when people start to feel like the stock market is headed for a dive, it's a self-fulfilling prophecy. People start getting bearish and scared, start selling their stocks, and then when prices go down, more people start to sell their stocks and drive prices down even further, etc. It's a vicious cycle.

So does the big spike up in Bullish Sentiment at the right side of the chart indicate that the stock market is headed for a big upswing? Who knows? All I know is that I'm going to follow the crowd and ride the trend whichever way it goes.