(By Louis Basenese)
In theory there is no difference between theory and practice. In practice there is. – Yogi Berra
I just returned from delivering a presentation on contrarian investing at the St. Regis in Park City, Utah.
My message to investors couldn't have been more straightforward: Look for extremes in market sentiment and investing activity… and do the opposite.
Well, here's the perfect opportunity to put this theory into practice…
Where Have All the Bulls Gone?
Just yesterday, the American Association of Individual Investors (AAII) released its latest sentiment readings. Apparently, the bulls – not the bears – have gone into hibernation.
Bullish sentiment dropped a full eight percentage points to 22.19%, the largest weekly decline since April 12.
I'm shocked, considering the S&P 500 Index rallied more than 2% over the last week. But now that virtually no one is optimistic about the stock market, that's all the more reason we should be bullish.
You see, during the current bull market, when bullish sentiment drops below 25%, stocks (almost) always rally over the next three and six months.
Take a look:
If you're worried this frame of reference is too short, fear not. If we extend our analysis back to 1987, when AAII started tracking sentiment, the same tendency holds true.
According to Bespoke Investment Group, when the bullish reading is one standard deviation below the long-term average, stocks rally 78.7% of the time. When the reading drops to two standard deviations below, stocks rally 100% of the time over the next six months.
Currently, the long-term average is 38.9%, with a standard deviation of 10.6.
So yesterday's reading of 22.19% is more than one standard deviation below the long-term average, which means there's roughly an 80% chance stocks will rally over the next six months.
Here's the key, though. If the reading drops another three-and-a-half percentage points, it would be a full two standard deviations below the long-term average. That would mean there's a 100% chance stocks will rally over the next six months.
Long story short: Based on the extremely low bullishness in the market, the time to buy stocks is now. Especially when we consider the other bullish fundamentals, which I outlined last Friday, working in our favor. Like analyst sentiment, unemployment trends, earnings reporting season and the fact that it's an election year.
Not to mention that stocks are trading on the cheap. The price-to-earnings ratio for the S&P 500 Index rests at 14, which is about 10% below the long-term average.
Bottom Line: Forget Yogi Berra's famous observation! When it comes to investor sentiment, there is no difference between theory and practice. When bullishness drops below 19%, stocks rally 100% of the time. By double-digit margins, too.
And with the latest reading within spitting distance of that threshold, I suggest that you act like a contrarian and do what's extremely unpopular – buy stocks! Six months from now, I bet you won't regret it.
Ahead of the tape,
Louis Basenese