It's a great headline, and for sure, it should have you running to sidelines tomorrow. But it is far from scary especially if you look at the data. I do agree with the premise -- when everyone is all in, there is no one left to buy, and oops!, air pockets are created. More specifically, the chart I am referencing is the one of the Investor Intelligence data shown in this article [3]. Yes, the percentage of bears is low -- very low. In fact, it is the lowest value since 1987 about 5 months before the "crash". But what does it really mean? Is it really the scariest chart for stock bulls ever? What does the data say?
So let's define a simple study where we buy the SP500 when the Investor Intelligence data shows less than 15% bears from its respondents. In the first study, we will hold our position for 13 weeks, and then we will look at a 26 week holding period.
13 week holding period
To evaluate the efficiency of each study, we will look at the Maximum Favorable Excursion (MFE) graph. See figure 1 for this study's MFE graph. MFE measures how much an individual trade gains in percentage terms before being closed out for a winning or losing trade. As an example, see the single trade inside the blue box in figure 1. This trade was initiated on November 5, 1976. It gained 6.59% (x-axis) before being closed out for a 1.05% (y-axis) winner 13 weeks later. We know it was a winning trade because the caret is green. This is not a particularly efficient way to make money -- that is, to make nearly 7% and see it all evaporate into a 1% winner. But this isn't our point here. What the MFE graph shows us is that there were 10 trades or instances over the past 40 years where the number of bears dropped below 15%. Utilizing the 13 week holding period resulted in 80% winners. 7 trades had a run-up greater than 5.5%; this would be those trades to the right of the blue vertical line. 4 trades gained over 9.5% during the 13 week holding period, and these are to right of the orange line. In data not shown, I can tell you that 80% of the trades had drawdowns less than 4%. The worst single trade drawdown was 7.2%.
Figure 1. MFE graph
[4]
26 week holding period
Now let's change the holding period to 26 weeks. The MFE graph for this study is shown in figure 2. Extending the holding period produced 2 less trades. 6 out of 8 trades were winners with all 6 of those trades gaining more than 9% at some point over the 26 week holding period; these are the trades to right of the blue line. In data not shown, 7 out of 8 trades had drawdowns less than 4%. There was one trade that had a "mega" drawdown of 8.5%.
Figure 2. MFE graph
[5]
So what does the data show when there are an extreme low number of Investor Intelligence bears? Over 13 and 26 week time periods, I would say that it is pretty favorable for equities. No guarantees of course. But certainly no reason to run for the hills either.
VISIT TACTICAL-BETA [6]