Investors Are Bearish So It’s Time To Buy

“You can’t time the market.”

It’s one of the most often-repeated investment phrases. And it’s wrong. History has shown that a simple ratio delivers impressive market gains. In fact, it appears when most investors have little desire to buy stocks.

Let me explain.

Every week, the American Association of Individual Investors (AAII) asks its members to answer one simple question in an online survey: Regarding the future direction of the stock market, are you bullish, bearish or neutral? Over the long haul, investors feel bullish about 39% of the time, and at times of maximum optimism, more than half of respondents will answer with a bullish response.

Yet at rare pressure points in the market, what Sir John Templeton once cited as “the point of maximum pessimism,” the entire crowd can turn bearish. Indeed at various points over the past three decades, the vast majority of respondents in the AAII survey express extreme bearishness. Presumably, such investors are selling stocks at these times and moving to cash. And that has proven to be a big mistake.

I’ve tallied the market performance whenever the crowd turns bearish, and on almost every occasion the market has gone on to post solid short- and mid-term gains.

Guess what? It just happened again. In a recently-completed survey, the number of investors in the bullish camp fell handily below 25%. In the most recent week, the sentiment rebounded a bit , to around 25%.

And history says it’s time to buy.

Source: AAII Sentiment Survey

(Note that a bearish reading in two or three successive weeks was narrowed down to just one week for that period, to avoid data skewing.)

In the past 15 years, investors have reviled stocks on 14 occasions. Of that, the market delivered a gain of at least 33% over the following three years nine times. The average three-year return on all 14 bearish-occasions is an impressive 42%. (Note that if the S&P holds at current levels by July 19, 2015, then the three-year gain will be 52%, raising that overall average.)

This contrarian indicator even works on a short-term basis: When investors are bracing for an imminent plunge, the market has actually moved higher over the next month on 11 of occasions.

Is This Time Different?
Historically speaking, there’s really not a lot of mystery to this. When stocks are rallying, much of the idle cash on the sidelines has been put into play. No amount of further good news can help if investors are already heavily-invested. Conversely, at moments of peak bearishness, idle cash rises, and it can take only the smallest shifts in market sentiment to lead that sidelined cash back into the market.

So why the weak current sentiment readings? Perhaps investors are fearing that all is not well with the market. After all, the Dow and the S&P 500 sit at levels not seen since November 2014.

Yet in some respects, the investing backdrop is far more favorable than it was in late 2014: The U.S. economy is again showing signs of broad-based strength, after a winter-related first quarter slowdown; Europe is finally rumbling back to life; the drop in global oil prices is finally easing the strain on many emerging economies that had been subsidizing fuel prices; and even mighty China appears to be avoiding the deeper economic slowdown that many had feared was coming.

Yet assessing how the world economy is doing, or the suitable current valuation levels for stocks, is not the point. The simple takeaway is that negative investor sentiment almost always correlates with future positive returns. So any concerns you may have about an imminent market correction appear to be misplaced.

Risks To Consider: What’s the impact of the Federal Reserve’s interest rate moves? A Greek exit from the euro? A hard Chinese landing? These are known unknowns, and investors need to be cognizant of them, but not fret about them.

Action To Take –> If the markets do show any further weakness, then it is likely to be short-lived. There is simply too much global cash that has too few other options. So any such market pullback is bound to attract fresh interest from dip buyers. It may not be wise to buy stocks right after they post sharp rallies, but if the news out of Greece or elsewhere causes a market rumble, you should be prepared to pounce on any weakness.

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