Thursday, September 8, 2011

Using AAII Sentiment Survey to Time the Market

I previously used Market Harmonics Investor Intelligence Survey bull / bear ratio to help me decide whether it would be a good time to invest. As a contrarian investor, a bearish sentiment would indicate a good time to buy and a bullish sentiment would have me stay on the sidelines or sell. However, since the 20th April 2011, they decided to discontinue publishing weekly data from Investors Intelligence and those who wish to obtain weekly Investors Intelligence reports have to subscribe to

Luckily there are other measure of investors confidence such as AAII Sentiment Survey or State Street Investor Confidence Index. The former is a weekly survey of American individual investors, the latter is an index based on North American, European and Asian investors portfolios published monthly.

Today, I'll study the AAII Sentiment Index between 1987 and today to see if it can be used by long term investors to time the market.

The first chart is composed of the S&P 500 (on top) and the 14-day moving average of the percentage of bullish investors (Bottom), since the raw data looks like noise to me.

We can see that during the previous bull market (between 1987 and 2000) on this chart, confidence seemed to build up over time, and since 2000, confidence seem to follow a slow downward trend.

The next chart is identical, except I add buy and sell signals. A buy signal is when the bullish sentiment moving average is at or under 30% and a sell signal when it is over 50%.

Based on those signals, an investor would have bought stocks numerous times between 1987 and 1994, possibly sell in 1997, buy again in 1998 and sell in 2000. During that period, this would have clearly been a winning strategy even tough the investor would have missed positive returns between 1997 and 1998, or possibly completely missed the bubble between 1997 and 2000. But positive returns are extremely easy in a bull market.

Let's see how it performed since 2000. There was another sell signal in 2002, but possibly the investor would not have acted on it due to all the sell signals in 2000. There was a brief buy signal in 2003 (that could have been missed) and then another sell signal shortly afterwards in 2003-2004, so the investor would have missed the 2003-2007 bull market.
Then there would have been a buy signal around Q2 2008 (Bad call) and another in Q1 2009 (Good call), before the last sell signal around Q1 2011.

To conclude, even though this method is far from perfect, it would still have outperformed the market between 2000 and 2011. Usually, one indicator is not sufficient to make a decision, and you may want to use
other indicators such as the 14-day Relative Strength Index (RSI) for the S&P 500 or the percentage of stocks above their 200-day moving average as explained in "Is the Stock Market fall over?" Long term investors should also follow Case Shiller CAPE (Cyclically Adjusted Price Earning), with a CAPE below 10 being a buy signal. But you'd have to be very patient...

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