Investors are suddenly feeling bullish about the stock market again–but that doesn’t mean you should start shorting it

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The same investors who thought the stock market was such a dreadful place last year have changed their tune. Now they’re excited about AI (it could be bigger than the internet!) and have dubbed mega-cap growth stocks “magnificent.” You might be feeling like you’ve seen this movie before. It’s called market top and star investor euphoria. The ending is terrible.

Using investor sentiment to identify key turning points in the market is a tricky endeavor. Your likelihood of success largely depends on the answer to one question: bull or bear?

Several organizations take polls to measure how investors are feeling about the market. Pairing their findings with market return data shows how predictive investor sentiment can be in bull and bear markets.

One such poll is the American Association of Individual Investors (AAII) Sentiment Survey. This weekly poll reveals whether individual investors are feeling bullish, bearish, or neutral on the market for the next six months. Think of this as the “mom and pop” investors survey.

The chart below shows how many investors identified as bearish over the past two years. Pessimism took hold in 2022 as stocks plunged into a bear market. The long-term average for AAII bearish sentiment (the red line) is 31.1%. Bearish sentiment reached 60.9% in September 2022–the highest level since the Great Financial Crisis. The market bottomed just a few weeks later.

The AAII Sentiment Survey can be useful in identifying bottoms. Whenever we hit a market bottom, bearish sentiment was elevated.

To see how the pros are feeling, we can turn to the National Association of Active Investment Managers (NAAIM) Exposure Index. This poll asks active investment managers what percentage of their portfolios are in stocks. The answers are used to build the index. A reading of 100 would mean fully invested in stocks. Zero would mean nobody owns stocks. The lower the index, the more bearish the pros feel about stocks. The long-term index average is 65.2 (grey line).

Looking at the same two-year period, professionals kept equity exposure low throughout 2022, but really reached their most bearish level right as the market was bottoming.

The Exposure Index hasn’t been around as long as the AAII’s Sentiment Survey–but we can still observe that exposure has been well below average at the end of the last three bear markets.

Indeed, the professionals seem to succumb to fear as readily as any other investor. When investors get this fearful, it often pays to get greedy. Ideally, you’re buying after most of the panicked sellers have already capitulated and stocks have hit rock bottom.

That’s all well and good for bear markets, but we’re in a bull market today. And bull markets get investors feeling better about the future. AAII bullish sentiment has averaged 42.1% so far in Q3 2023–materially higher than the long-term average of 37.5%.

The NAAIM has similarly been elevated at 75.2 over the same period compared to the long-term average of 65.2.

The contrarian in you might be tempted to use the recent spike in investor optimism as a sign to exit stocks–or even short the market.

Unfortunately, it doesn’t work that way. Market tops don’t always exhibit a huge departure from normal sentiment. Here’s how bullish sentiment in the AAII survey looked during the last five market tops:

High bullish sentiment isn’t indicative of a top. More often than not, bullish sentiment is pretty average when a market top has formed.

Here’s how the NAAIM Exposure Index looked at market tops:

Two of the three bull market tops saw the pros taking on above-average exposure. But the deviation from average is not nearly as great as in bear markets. Note that the Exposure Index has registered as high as 120.6 on the high side, so it can go quite a bit higher than 100 and lower than zero. The lowest-ever recording was -3.6 (and yes, it was a good time to buy).

Using investor sentiment as a contrarian indicator can be great for calling bottoms. Tops, not so much.

Michael Joseph, CFA, is a portfolio manager and deputy chief investment officer at Stansberry Asset Management. This report should not be construed as investment advice. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

The opinions expressed in commentary pieces are solely the views of their authors and do not necessarily reflect the opinions and beliefs of Fortune.

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