The Wall Street Climbs a Wall of Worry

The AAII (American Association of Individual Investors) survey, published weekly, is widely regarded as one of the most closely followed barometers of retail investor sentiment in the United States.

Despite an exceptionally strong week for equities and broad participation across the rally, sentiment amongst AAII investors has become increasingly downbeat.

According to the latest survey, almost 48% of private investors expect the market to decline over the next six months, whilst only 30% describe themselves as bullish.

Such readings are far more commonly associated with the aftermath of a significant correction than with an index trading within touching distance of fresh record highs. The summer rally, which many had dismissed as improbable, continues to gather momentum, and there is every chance that the market could register new highs before June is out.

From a behavioral finance perspective, this is an encouraging backdrop for equities. Historically, the most durable bull markets have advanced not on waves of optimism but on a foundation of persistent skepticism and repeated expectations of an imminent correction. Whilst the majority of investors remain cautious, a considerable amount of capital is still waiting on the sidelines, creating potential demand every time the market pushes higher.

That is precisely why the current pessimism can be viewed as a classic contrarian signal. Provided the macroeconomic backdrop remains stable and corporate earnings continue to exceed expectations, equities may well continue advancing in defiance of prevailing sentiment. Market history suggests that bull markets seldom come to an end when investors are reluctant to buy; they tend to finish only when investors become convinced that nothing can possibly go wrong.

Equally striking is the growing divergence between price action and investor psychology, creating what is often referred to in the City as a "wall of worry". Strong bull markets have a habit of climbing this wall, with every fresh high greeted by doubt rather than euphoria. Modest pullbacks are then eagerly bought by those who had previously hesitated, providing the market with a steady source of fresh demand.

Taken together with expectations that monetary policy may gradually become more accommodative over the coming quarters and the continued resilience of corporate earnings, the current sentiment profile appears more supportive than alarming. So long as investors remain busy searching for reasons to expect a correction, the market retains every opportunity to confound consensus and press on towards yet another record high.

Trade smart with Headway