S&P 500's 10% Correction Leads to Extreme Bearish Sentiment

Investors have faced significant challenges this year, with the S&P 500 experiencing one of its swiftest 10% corrections in the past 50 years, nearly plunging into a bear market. This has led to a stark decline in market sentiment, typically seen during severe market downturns or financial crises. Interestingly, this extreme pessimism occurred when the S&P 500 was only about 3% below its record highs.

The AAII survey revealed that the number of bullish respondents dropped below 20% on February 26th, while bearish responses surged above 60%. These readings, considered extreme, have historically correlated with significant market lows since 2000. Extreme sentiment readings often serve as contrarian indicators, with highly bullish sentiments marking short-term market peaks and highly bearish sentiments signaling market bottoms.

However, this time, the sentiment readings from late February did not align with historical patterns. The S&P 500 continued to decline, reaching a low in April that was nearly 20% below the levels when sentiment first turned extremely bearish. This raises the question of whether sentiment is still a contrarian indicator or if it has evolved into a leading indicator, preceding larger market movements.

Today's investors are no longer reliant on traditional news sources for market updates. Real-time alerts and social media have accelerated the flow of information, allowing investors to react swiftly to market changes. This rapid dissemination of information has led to a more dynamic investment landscape, where sentiment can shift as quickly as stock prices. Retail investors, in particular, often view market pullbacks as buying opportunities, a mentality that holds true during both minor corrections and steeper downturns.

Despite the changes in market dynamics, such as the introduction of electronic trading and the steady flow of 401K funds, human emotions remain a constant factor. Fear and greed continue to drive investor behavior, much like they did a century ago. While artificial intelligence and algorithmic trading may influence market emotions, the underlying human response to market highs and lows persists.

In the current market environment, sentiment has not acted as a contrarian indicator but rather as a leading indicator. Extreme bearish sentiment has preceded significant market declines, and through April, these sentiments have only modestly improved. This trend was also observed in 2022, where early signs of extreme bearish sentiment preceded the market bottom later in the year. This suggests that investors are reacting more quickly to changing market dynamics, but it is also possible for sentiment to become overly bearish early in a decline before markets eventually bottom on bearish sentiment. Regardless, markets are unlikely to bottom on bullish sentiment.