When it comes to market bullishness or bearish, there’s an adage that says, “sentiment follows price.” However, recent market action has broken that trend, with investor sentiment falling even as we sit all-time highs.

The American Association of Individual Investors (AAII) surveys its members weekly on the direction they believe the stock market is headed over the next six month, with responses ranging between up (bullish), no change (neutral), or down (bearish). One gauge of investor confidence is the Bull-Bear Spread (AAIISPREAD), calculated by subtracting the percentage of bearish respondents from the percentage that are bullish. A positive reading indicates more bulls than bears, while a negative reading suggests the opposite.

This week's survey showed only 28% of respondents had a bullish outlook compared to 49.5% with a bearish outlook, resulting in a spread of -21.5%. That level sits in the bottom 10% of historical surveys, placing us in abnormal territory. With bearish sentiment returning, should we brace for worse things ahead?

Interestingly, historical data suggests otherwise. Periods of low sentiment have often been followed by favorable market performances, while high sentiment tends to precede more muted returns, particularly at the extremes. Previous instances around current levels averaged solid returns over the following year, with one- and three-month returns ranking the highest of any group. That said, today’s reading is notable not only for its low level but also for occurring so close to all-time highs. As such, should we temper our expectations given the market’s elevated positioning. 

Fortunately, history again points towards a constructive environment for equities. Nearly 90% of similar instances were positive after a month while the average return over the next several months significantly exceeded baseline expectations. While history doesn’t repeat, it often rhymes, and fading the market’s pessimism has historically worked out more often than not. Sentiment alone can’t fully predict market direction, but the generally positive takeaways from low-confidence periods are another sign of underlying strength, especially in the context of domestic equities’ long-term relative leadership.

Early this year, there had been speculation that 2025 could be a strong year for small caps – the logic was, because small caps generate most of their revenue in the US, they would be less affected by tariffs (and retaliatory tariffs by other countries). As with other predictions for this year – like outperformance by domestic equities over international equites – strength in small caps has not come to fruition. Year-to-date (through 9/10) the Russell 2000 (RUT) has gained 6.63%, trailing the S&P 500 (SPX) by more than 4% and while the large cap indices have hit a series of all-time highs over the last couple of months, RUT currently sits about 3.5% below the record it hit last year. Meanwhile, small caps occupy the bottom three spots in the DALI size & style rankings.

Recently though, there have been signs that small caps may be improving. Over the last 30 days, US Small Cap Value has been the most improved group in the Asset Class Group Scores, gaining 1.15 points, bringing its average score to 3.58. The US Small Cap Blend, All US Small Cap, All Small Cap, and US Small Cap Growth groups are also among the top 10 most improved groups over the last 30 days.

After Small Cap Value, Financial-Banks is the second most improved group over the last 30 days, which has helped drive the improvement in small caps, especially small cap value. Financials are, by far, the largest exposure in the iShares Russell 200 Value ETF (IWN) at nearly 39% and the iShares Russell 2000 ETF (IWM) at around 26%.

Expectations for lower rates appear to be a major contributor to the improvement in small caps and banks. On August 12th, on the heels of a cooler than expected CPI report, RUT outperformed the S&P 500 (SPX) by 1.86%, one of its largest single-day margins ever. Since then, the prospects for easing have increased thanks to softening labor data helping drive further improvement.

That banks would benefit from falling rates may seem counterintuitive as we often think of banks as benefiting from higher rates. If you pay little or no interest on deposits but lend at market rates, you make more money when rates are high. But, if you recall the 2023 “banking crisis,” that saw three small- to mid-size banks fail, worries about banks’ balance sheets contributed to the distress. Banks had bought lots of long-term bonds (especially Treasuries) when interest rates were low, the value of those bonds cratered when interest rates rose. Although it’s been more than two years, banks are still carrying many of these bonds as selling them would have meant realizing large losses. If interest rates fall, bond values rise, improving banks’ balance sheets.

Another reason lower rates help small caps is they may be more reliant on debt financing than their large cap counterparts. When rates fall, so do their borrowing costs, boosting profitability.

Even with the recent improvement, the technical picture for small caps is OK but not stellar. As mentioned above, small caps occupy the bottom of the DALI size & style rankings. Meanwhile, IWM and IWN have fund scores of 3.29 and 3.40, respectively. Of the iShares Russell 2000 ETFs, only the growth fund, IWO, has a score above 4.0. All three funds have acceptable fund scores, so there is no reason you couldn’t add exposure to any of them if you were so inclined. However, large cap stocks still have a clear relative strength advantage. In recent weeks, the market has become more convinced that rate cuts are imminent – fed futures are now pricing in a 100% chance that the Fed will cut rates at its meeting next week and about a 90% chance of another rate cut in October. So, it will be worth keeping an eye on to small caps to see if they can build on the recent improvement.

Daily Option Ideas for September 11, 2025