AAII and Market Sentiment Indicators – Trading Strategies with Index and Backtests

Can you make money on a bullish or bearish AAII market sentiment indicator? When the pessimists turn optimistic and the optimists turn pessimistic, a bottom or top is formed. If you understand market sentiment and where traders and investors feel the most pain or euphoria, you have gained a wealth of knowledge about potential turning points. Reading the aggregate market mood can be very valuable and profitable. What are market sentiment indicators and how can you trade them?

You can trade on market sentiment indicators by using the AAII sentiment index. When the AAII index is very bullish, you can expect mediocre or below-average returns in the next four weeks. When the AAII index is very bearish, you can expect above-average returns over the next four weeks. That said, we believe there are better ways and indicators to trade the market.

Let’s get going, and we start with the basics by explaining what market sentiment is:

What is market sentiment?

Let’s first start by explaining how we define market sentiment:

Market sentiment refers to the attitude of the players in the market. Are they bullish, neutral, or bearish? We can argue that market sentiment measures the aggregate mood of investors and traders.

Benjamin Graham made a fantastic analogy of the market in his legendary book called The Intelligent Investor, a book we recommend whether you are a trader or a long-term investor. Benjamin Graham refers to the sum of the market as Mr. Market. Graham argues that Mr. Market is manic-depressive. Sometimes he is in a good mood, and sometimes he is in a bad mood. It swings back and forth between these two levels all the time.

Market sentiment is crowd psychology. When the overall market is bearish, we have a bearish market sentiment, and vice versa.

What is a sentiment indicator?

A sentiment indicator is an indicator that measures the sentiment of Mr. Market. Is Mr. Market bullish, neutral, or bearish? The sentiment indicator is an oscillating indicator that goes up and down.

What are the most used sentiment indicators?

To our knowledge, the AAII sentiment index is both the most used and referred to. This is the sentiment indicator we have used in our backtests below. Another popular sentiment indicator is the Investors Intelligence Bulls & Bears.

However, we might argue the VIX indicator is also a sentiment indicator, and the VIX is, of course, both more known and used.