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Investor sentiment sends the wrong message

Turmoil in the markets has investors worried for 2016. But the pain in the downturn could already be behind us, and there could be ways to capitalize.

A survey of investors last week showed near-record low confidence in the market over the next six months, a sentiment that seemed vindicated Friday when the S&P 500 fell 2 percent to cap an 8 percent drop to start the year.

The thing is, anxious sentiment seems to lag behind actual market movements. According to CNBC.com analysis, the spread between bearish and bullish sentiment is only correlated with weekly market returns in the month of the survey. That means that sentiment has little predictive power and doesn't really provide actionable intelligence for an investor.

Before Friday's rout, investor sentiment shrank to a near-record low, according to the survey released Thursday by the American Association of Individual Investors. Bullish sentiment sat at 17.9 percent, a figure reached only 17 times (including last week) since the weekly survey began in 1987. Most of those times were in 1988 and 1990.

The closest that bullish sentiment came to this level during the Great Recession was in March 2009, when it hit 18.9 percent. The last time it was at the 17.9 level was April 2005.

Less than a fifth of investors surveyed were feeling bullish about the next six months, while nearly half (45.5 percent) were feeling bearish.

Bearish sentiment rises much more quickly and has hit similar highs during the recessions in 1990 and 2008-09. Overall, 115 weeks have hit this level of bearish sentiment since the survey began. In terms of the spread between bullish and bearish sentiment, 43 weeks have been this divergent, including much of 1990 and 2008.

That means investors' bearish feelings have outweighed bullish less than 3 percent of the time in the past 25 years.

Research suggests that low investor sentiment is actually a contrary indicator, meaning that when it's down, the market is more likely to start rising soon. The idea is that by the time the crowd is feeling glum about the market, it's time to start buying.

The spread between bullish and bearish investor sentiment (bullish minus bearish sentiment) is weakly correlated to the weekly return of the S&P 500 — but it's lagging. So it's correlated with negative events that have already happened.

The correlation disappears or even becomes slightly negative when you compare the survey results to the weeks after it comes out. That suggests that you can't rely on investor sentiment as an indicator that the market may tank. If sentiment is low, the worst is likely over.

Market analysis using the Kensho tool shows that while you could lose money by selling stocks during a week with poor sentiment, there's no indication that you can be sure to benefit from buying during times when investors are bearish. Analysis on the stock market's return at one, three and six months after a low sentiment score, as well as a full year in the future, showed that none had statistically significant returns above the historical norm in any sectors.

So if you buy during a period of low sentiment, you can't expect with reasonable certainty to gain beyond the typical return for the market over a given time period.

The only statistical significance was if you bought stocks a month before investors' sentiment was this low and sold the day the survey came out. In that case, you'd be down a median of 4.5 percent. That means the only thing investor sentiment is actually showing is that the market has been performing poorly and you shouldn't take it as a sign to sell.