This week’s chart compares institutional and retail investor sentiment using two established indicators. Institutional sentiment is represented by the National Association of Active Investment Managers (NAAIM) Exposure Index, which measures the average U.S. equity market exposure reported by NAAIM member firms (i.e., organizations that actively manage client portfolios). Reported exposures for this index include -200% (leveraged short) to -100% (fully short), 0% (market neutral), +100% (fully invested), and +200% (leveraged long), capturing the breadth of positioning from extremely bearish to highly bullish. Retail sentiment is represented by the American Association of Individual Investors (AAII) Sentiment Survey, which reflects the bullish-minus-bearish spread regarding the six-month outlook for stocks across individual AAII members (i.e., retail investors). When analyzed together, these indicators offer perspective on how both institutional and individual investors view the near-term prospects of equity markets.

Readers will note that these two indices have moved in tandem throughout most of the last several years but have diverged significantly in recent weeks as retail investor sentiment has plunged. It is not entirely clear what’s driving this latest divergence, but several factors likely play a role. Specifically, renewed U.S.–China trade tensions, the ongoing federal government shutdown, and interest rate uncertainty have likely weighed more heavily on retail investors, who tend to be more influenced by headline noise. Institutional money managers, on the other hand, appear to be maintaining confidence in healthy corporate fundamentals and the broader economic backdrop. Regardless of its exact cause, this divergence underscores the notion that sentiment data should be viewed as context-dependent rather than as a market timing signal.

Barring a significant equity market drawdown in the coming weeks, the current bull market will turn three years old in October. The gains posted by the S&P 500 Index during this time have certainly been robust, with the benchmark delivering 24% and 36% returns in the first and second 12-month periods of the current bull market, respectively. This strong performance has led many investors to question if stocks will continue to deliver in the near future. Interestingly, bull markets in decades past have seen positive stock returns well into the third, fourth, and fifth years; however, these gains tend to be more muted than those notched in the first two years. Over the last 50 years, the pattern has often been the following:

• Year one: Explosive gains are recorded as markets rebound from oversold conditions. The average return of the S&P 500 Index in the year after a bear market trough is roughly 37%.
• Year two: Equity returns are still strong but less extreme, with the S&P 500 Index averaging a return of 17%. Earnings growth and investor confidence begin to stabilize.
• Years three–five: Equity momentum slows. Average returns compress to 8%–13% and markets become more vulnerable to corrections.

To expand on the final bullet point, the third, fourth, and fifth years of a bull market often prove shakier given the convergence of several structural factors. For instance, early in the cycle, central banks and governments typically provide aggressive stimulus to allow markets to recover from troughs; however, inflation and financial stability risks typically arise within a few years. These factors usually prompt tightening from policymakers, which can constrain equity performance. At the same time, the sharp rebound in corporate profits that characterizes the first two years begins to normalize, making year-over-year comparisons less favorable. Valuations, which tend to increase in the early innings of a bull market as confidence returns, also usually peak around year three. This causes any future stock gains to be more dependent on genuine fundamental improvements (i.e., earnings growth) rather than continued multiple expansion. Finally, after two years of strong performance, investor sentiment often shifts from optimism to caution, with growing fears that current conditions may not persist. While it is impossible to predict the trajectory of equity markets from here, it may be prudent for investors to expect more muted gains from stocks in the years ahead simply based on historical patterns.