What is the market sentiment index?
The market sentiment index measures individual investors' feelings, or expectations, as 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.
What is the Bull/Bear ratio?
The bull/bear ratio is the same as the market sentiment index, although a bit more specific. Indeed you can measure market sentiment by either looking at the single ratio of how many surveyed investors are optimistic (aka bullish ratio), or you can put it relatively to the ratio of pessimistic investors (aka Bull/Bear ratio). I found out in my own simulation that the single Bullish ratio was a better indicator than the Bull/Bear ratio as long as I averaged it over 8 weeks and you invested with a long-term timeframe (at least 8 years).
What is the current market sentiment?
American Association of Individual Investors (AAII) vs. Investors Intelligence sentiment
The Investors Intelligence Bull/Bear Ratio is a sentiment metric focusing on US professional market advisors rather than individual investors. They provide a sample chart to the public but have a paywall to access the underlying data.
The American Association of Individual Investors (AAII) instead is an online survey any individual investor member of the association can take. Technically you don´t have to be a US investor to take it, but it still focuses on the US market.
Is the individual investors´ sentiment a good indicator?
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." Another way to put it is to go back to what a market is in its essence: a demand vs offer problem. If very few people think the market will go up, then the demand for buying assets is low, hence depressing prices.
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. It turns out that buying while the fear is high (bullish ratio 8 weeks moving average under 27%) AND the market is in bear territory beats the "invest every month no matter what" scenario by an average of 9.1x! However, it was not such a good indicator if your investing time horizon is less than 8 years. Check here the complete analysis.
What is the level of market fear, also known as the "market fear index"?
The fear index is just another way to refer to the market sentiment, but if it focuses on its pessimistic side? The fear is high when the bullish ratio gets below one standard deviation from its mean. In the case of the AAII bullish ratio, that would be below 28%, or below 30% if you average it over 8 weeks.
What is the maximum level of drawdown seen on records from high fear levels?
When the 8-week average bullish ratio is 1 standard deviation below its mean (below 30%), the maximum subsequent drawdown from these levels (measured as the weekly close price of the S&P500) on records is -46%. The maximum drawdown occurred back in May 2009, almost a year after the bullish ratio 8 wks avg had crossed the 30% mark in June 2008. However, from the 17 times this ratio went into the fear zone, the mean drawdown from there was -11%, with a std. deviation of 10 percentage points.
When the 8 wks avg bullish ratio crosses 2 std deviations down (below 22%), it never went further down more than -12%, which happened once in the 1990s.