It's funny how humans pay close attention to stories over pure logical thinking. My day job's most crucial skill is storytelling, not the data analysis itself. You can make great analysis nobody will care about if you cannot tell a nice story to show it. Journalists have the same imperative, few people would read their articles if not for their capacity to make them memorable, hence attractive to the "right-brain". On May 20th, 2022, it was all about "the US entered the bear market territory," and a few hours later, the headlines were "Stock market rally out of the bear market".

Nonsense, the primary US index was down by 19%. Why would one percentage point matter? It actually does because investors are as sensible to stories as everyone else. This is why I am paying close attention to a market sentiment metric called the "bullish ratio". The bullish ratio is based on the feelings and expectations of individual investors surveyed by the American Association of Individual Investors (AAII) . Bears are people who believe in doomsaying stories (aka the market will go down further). Bulls prefer stories with a happy ending (aka the market will go up). AAII published data goes back de 1987, making it a nice dataset to play with. I did just that as a geeky analyst, and here are my findings.

Investors and advisors are about as bearish as it can get.

According to the AAII bullish ratio 8-week moving average, only 22% of investors are bullish about the future market story. This is well below its "normal" range (within the standard deviation) of 30% and 46%. We see the exact same pattern from the Investors Intelligence Bull/Bear Ratio, another sentiment metric that focuses on professional market advisors rather than individual investors.

Is the Investor Sentiment Index a good investing signal?

Pundits refer to these sentiment metrics as "contrarian" indicators. It's a fancy way to put what is also known as Warren Buffets' most famous quote: "be fearful when others are greedy, and greedy when others are fearful."

As a result of greed, prices typically rise. An overpaying buyer might end up with an asset that provides weak returns. Hence, a good investment opportunity may arise when others are fearful. But is it really? I had to run a few simulations to check this supposed market wisdom.

Simulating returns based on the "fear" index

I assumed fear was high enough when the AAII bullish ratio 8 weeks moving average got below its standard deviation of 30%. For each week this was true, I simulated scenario D where one would buy 100 USD of the SP500 index. The control scenario B was that the same amount invested in scenario A was spread equally every week, independent of the market sentiment. I then compared the total yield of each scenario with 3 different investing time horizons: 5, 10 and 20 years.

As you can see, this strategy does look good, beating the control scenario by an average of 3.2x. Not bad at all. The market wisdom seems to be accurate, which means now would be a good time to invest.

What if we combine bear market with the fear index as a buy signal?

I ran a second simulation. This time focusing on bear or "near" bear markets (like the one we are in right now). Scenario A consists of investing 100 USD for each week the bullish ratio is below 27% (I got more conservative), AND we are in a bear market. Control scenario B consists of equally investing each week of a bear market, no matter the sentiment. I also added Scenario C, where one equally invests each week of a bear market independent of the fear index.

Scenario A trumps every other scenario. Buying while the fear is high AND a bear market beats the control scenario by an average of 9.1x!

Note how the "passive investor" is doomed to invest for at least 20 years to get a meager return.

Also, note how all scenarios get negative returns if your time window for your money is 5 years or less.

When everybody gets pessimistic about the market, it has usually been a good buying signal for investors with at least an 8 years time horizon. If you need your money in less than 8 years, you are probably better off without investing in the stock market.

Feeling FOMO already? Read this first

I wanted to understand how much of a rush one should feel when seeing market conditions like the one we live in. So I calculated scenarios where one keeps investing for 3, 6, 12, 18 and 24 months since the beginning of a bear market. Turns out the best average return over the last 4 bear markets is when one invests up to 18 months after entering a bear market, so you better. So FOMO no more.

Is it time to be greedy, or fearful?

We technically escaped a bear market (even though the NASDAQ is deep into it), but the fear index kept increasing. Combining a bear market with high fear has been a good buy signal if history is any guide. The valuation Guru Aswath Damodaran recently valued the S&P500 according to various scenarios. He simulated different levels of risk-free rate (which will depend on how much inflation can be controlled), equity-risk premiums and future Earnings.

There is significant divergence of views on every aspect of value, from where https://t.co/jhPnIWMCRT rates will end up, to whether risk premiums will continue to rise, to how a slowdown may damage earnings, leading to a wide range of values for the index. https://t.co/IctOQRYzih pic.twitter.com/dY1qFWZGcx

— Aswath Damodaran (@AswathDamodaran) May 6, 2022

Giving recession a probability of 40%, like Yardeni's report, to Damodaran's model means the S&P fair value should be around 3.600, with a std. deviation of 800. I know it is pretty broad, but I guess we will see a real bear market sometime this year. I am keeping my short position on the S&P500 and will not open new positions unless mirroring it with a short S&P for the same amount. If we enter a bear market, I will start opening new positions without any hurry. It usually takes 18 months to get the most of a "dollar averaging the dip" strategy from a bear market start.