Despite A Rally In Stocks, Investors Say They're Miserable

On Friday, the S&P 500 (SPX) once again surpassed the significant 4,200 level, indicating a potential breakthrough of the 400-point trading range that has persisted for nearly seven months. The prevailing sentiment is supported by several factors, including alleviated concerns surrounding U.S. regional banks and the government debt-ceiling, as well as calmer conditions in bond markets. Traders have welcomed the prospect of easing inflation and a pause in Federal Reserve rate hikes, further bolstering market sentiment.

An additional driver for market optimism is the emergence of a new structural paradigm. Hopes for a surge in artificial intelligence (AI) advancements have propelled the Nasdaq Composite (COMP) to its highest level since August. This surge in market enthusiasm is evidenced by the record-high volume of Nasdaq 100 call options, reaching levels not seen since 2014.

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However, it is worth noting that despite the prevailing market optimism, there is a prevailing sense of discontent among market participants. Even active investors are expressing sentiments of dissatisfaction at currently depressed levels. Paradoxically, this dichotomy suggests the potential for further market gains, as George Smith, portfolio strategist at LPL Research, asserts.

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The latest weekly data from the American Association of Individual Investors (AAII) reveals a decline in the percentage of individual investors who hold bullish short-term market expectations, now standing at 23% compared to 29% the previous week. Smith notes that this represents the lowest level since the end of March and is significantly below the long-term average of 34%. Although the percentage of bearish investors decreased compared to the previous week, it still remains above the long-term average of 32%. Consequently, the spread between bullish and bearish sentiment stands at minus 17%, contrasting with the long-term average of plus 2%.

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As depicted in the accompanying chart, investor sentiment, as measured by the spread between bulls and bears in AAII data, currently deviates by more than one standard deviation from its long-term average. 

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Smith highlights that while the concerns contributing to individual investors' prevailing apprehension (such as inflation, higher interest rates, and recession fears) are valid, the negative sentiment they have generated can serve as a potential catalyst for positive forward returns from a contrarian perspective.

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Furthermore, data from Vanda Research reveals a decline in stock purchases by retail investors, particularly following the collapse of SVB. This indicates that there is latent support for stocks, with numerous potential buyers waiting on the sidelines for current worries to subside, as emphasized by LPL's Smith.

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Smith further notes that extremes in pessimism, as reflected in AAII data, tend to be bullish indicators for near-term stock market returns, while excessive investor optimism tends to portend a bearish near-term outlook. 

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When the bull-bear spread falls within the range observed presently (between 1 and 2 standard deviations below average), the S&P 500 historically exhibits strong returns over three, six, and twelve-month periods, with the six-month period demonstrating the second highest returns, according to Smith.

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