Contrarians get a bad rap. We are generally considered to be a disagreeable lot.
According to the stereotype of contrarians, a market rally only inspires us to sell. And, the stereotype continues, a market plunge finds us trying excitedly to “catch falling knives.” It reminds me of Monty Python’s wonderful sketch called, “Argument Clinic.” Its premise is that the clinic’s purveyor is paid to argue with the customer. The joke is that the customer believes he is purchasing a reasoned debate. Instead, all that he gets is simple contradiction and disagreement.
Such one-dimensional contrarian investors are not investors for very long. As John Maynard Keynes famously said, “Markets can remain irrational a lot longer than you and I can remain solvent.” It’s too bad that true contrarianism is so misunderstood, because it is still pretty simple – and potentially very profitable.
Profitable contrarianism does not reflexively bet against price direction. Quite the opposite. A contrarian appreciates what is inspiring the market’s current trend. By first understanding what the trend is prioritizing, then it can be determined when that priority has been fully appreciated by price. The opposing view may be correct, ultimately – that a company’s earnings cannot meet analysts’ estimates, or that an economic report will disappoint, or that a country’s ratings downgrade is unjustified. A trend may be maturing, and preparing to reverse direction simply because its sponsorship has become fully invested. Or, a recently-begun trend may be reacting too aggressively to surprising news.
The current price direction is affected by what the majority of market participants believe right now to be correct. And that majority may grow. A true contrarian need not even value a market or a stock in order to identify when its current trend is ending. Often, having no opinion is more helpful than having an opposing opinion, even if that opposing opinion ultimately proves to be correct. “Ultimately” can take a long time to arrive. So, we monitor other metrics and observations that tend to identify a trend’s end.
Contrarianism is the art of identifying extremes in Fear and Greed, the phase when a majority of market participants has already acted on a common opinion. That is when a stubborn trend becomes vulnerable to reversing direction. I have separated the more useful contrarian methods into three categories:
TRADITIONAL
Traditional methods of identifying a trend’s extreme are typically applied to the broader indexes, as in the Dow, S&Ps, and NASDAQ. That may assist in seeing when an individual stock’s situation is more vulnerable to reversing direction along with the market. There are several ways that contrarians identify a change in the market:
1. Sentiment. A trending market is produced by a growing number of like-minded investors that perceive a similar future value. Human nature prevents that number from ever reaching 100%. In fact, it rarely comes anywhere close. But it can reach levels that tend historically to occur when a common perception has saturated market participants. From a contrarian perspective, a sentiment extreme means that the shared perception can no longer impact price, so the trend can then reverse direction. Various sentiment gauges are widely available. The American Association of Individual Investors (AAII, http://www.aaii.com/) publishes a weekly survey of its members’ expectations for market direction. Newsletter reviewer Mark Hulbert publishes a Stock Newsletter Sentiment Index (HSNSI) that looks for extreme readings among short-term market timers. Investors Intelligence (http://www.investorsintelligence.com/) publishes its Advisor Sentiment numbers with the same goal, but assessing a longer time horizon.
2. NYSE Short Interest. This gauge of professionals identifies extremes in complacency. Ratios are derived from the number of a stock’s outstanding shorts and its float (shares available for trading). Professional shorting is not necessarily motivated by a bearish opinion, just as buying back the shorted shares to cover the short need not be done for bullish reasons. So, extremes in a short interest ratio identify when professionals have become complacent that the current trend will continue. Hint: It never does.
3. Put-to-Call Ratio. Options are a popular trading vehicle for smaller investors. Their leverage offers a cheaper commitment to participate in a stock’s uptrend or downtrend. A “put” price can increase as a stock’s price declines. A “call” can increase in price if the stock rises. The ratio between currently outstanding puts and calls will reflect whether smaller investors are behaving much more bullishly or bearishly than normal. This sentiment extreme is considered more contrarian than most indicators since it tends to reflect non-professionals, who tend to be late or otherwise wrong about a trend.
4. Margin Debt. Investors are more willing to borrow money on margin toward purchasing stock when they are more confident in prices rising. And investors are more confident in rising prices when prices have been rising. Margin Debt is publicly reported, and it tends to reach its historical extremes when prices have been rising for an extended period, and when fewer prospective investors remain on the sidelines.
5. Odd Lots. Smaller investors often have very poor timing. And smaller investors that are poorly funded are forced to buy in less than 100-share blocks, or “odd lots.” This has become less relevant in the age of ETFs, and is more representative of consumer darlings like Apple Computer (AAPL) and Google (GOOG) that trade for hundreds of dollars each.
6. Short Interest Ratio. Outstanding short interest in an individual stock largely quantifies contrarian opinion. Shorts have actually laid their money on the line. By doing so, those shorts have already discounted their bearish opinion in the shorted stock. When compared to the “float” (shares available for trading), the short-interest ratio can be extrapolated to determine how long, in days, it would take investors to cover their short positions if a stock price began to rise. The more days it takes, the more buying pressure would be generated by shorts covering if their opinion were to start being disproved.
ANECDOTAL
Some contrarian methods are not so easily quantified. Anecdotal observations can be just as revealing of extremes in fear and greed. Perhaps these are not as precise and as consistent as traditional methods, but they often compensate by being more profound. And by being more anecdotal than statistical, they are more easily grasped by non-professionals.
1. Headlines. A steady stream of good news can induce complacency among market participants. A steady stream of bad news can induce hesitation. The contrarian notices when all recent news seems to lean one way or the other. All it takes is one or two headlines with a different spin to make participants suddenly worry about being overexposed or underinvested. They rush into or out of the market, taking price hits sharply in one direction or the other. This is especially effective when it is counterintuitive. For example, crude oil prices had been rallying sharply in the lead-up to America’s first war in Iraq, Operation Desert Storm, as markets feared supply interruptions. But in conjunction with the invasion, a release of Strategic Oil Reserves drove price down over 30%. Fearful headlines made market participants all the more surprised at the “good” news.
2. Cover Story. Weekly and national periodicals like Barron’s Magazine and Business Week take their covers more seriously than any other part of their publication. It is what attracts buyers at newsstands and it is what defines that week’s theme, so editors give careful consideration to what will be most acceptable or intriguing. By definition, a national periodical’s cover represents something that has probably worked its way well into the mainstream. Also by definition, if the cover is an investment thesis – e.g. “Walmart is Taking Over Retail,” “There’s No Stopping Microsoft,” “The Death of Equities?” – then from a contrarian perspective, that thesis is probably fully invested already. Similarly, one investment research firm monitors financial stories crossing over onto the mainstream Drudge Report website, and then assumes from a contrarian perspective that the story has been fully discounted in price.
3. Experiential. From cocktail party chatter to locker room banter, you’ll notice when a conversation is dominated by a single topic. When that single topic is the stock market, the contrarian recognizes that the current trend is probably nearing a turning point. Alternatively, conversations can resemble arguments when the discussion is among stock market professionals. I started the web’s first traders chat in 1995, and soon found its level of discourse to be an excellent indicator of a trend’s health — things became quite heated when trending was about to reverse direction. JP Morgan (or Joseph Kennedy in some versions) famously sold his stock portfolio after his shoeshine boy offered him stock tips. Alarmed at there being no one left to invest, Morgan (or Kennedy) avoided the 1929 Crash. Or something like that. Like I said, there’s nothing scientific about anecdotes.
PERSONAL
Until the machines take over entirely, every contrarian indicator is at some level a reflection of sentiment among humans. The following methods measure an individual’s sentiment.
1. Wrong-Way Corrigans. Have you ever noticed how your brother-in-law, your next-door neighbor, and the trader sitting next to you are constantly touting their latest stock idea? Ever notice how often they are wrong? Some people simply have poor instincts for investing. Rather than shun their insight, consider using it for guidance – contrary guidance. And the next time you want a sounding board on your latest pick, or you want a quick gauge to market sentiment, ask your personal contrary indicators for their opinions.
2. 15 Minutes and Counting. The first time I was ever “on” CNBC in July 1996, host Ron Insana quoted my blog, in which I was poking fun at market analyst Elaine Garzarelli’s latest market call. Her prominence had been earned by warning publicly against stocks just before October 1987’s crash. She remained prominent despite a string of badly timed calls. The next generation’s version of Garzarelli may be Nouriel Roubini. His Black Swan call in 2008 is legendary, but his many calls in the subsequent four years were simply wrong. Beleaguered hedge fund manager Whitney Tilson became an example in 2012 for taking a suddenly very poor performance and compounding it. Each one was once a great home run hitter, with a knack for getting the spotlight’s attention at the worst possible time I only hope they embrace Oscar Wilde’s proposition that “the only thing worse than being talked about poorly is not being talked about at all.”
3. Gut and Strut. Listen to your gut, but interpret it correctly. We’ve all had that feeling when a sudden price move goes against our position, or opposite to our opinion. For me, it can almost literally rip a hole in my gut. It is uncanny how often that maximum feeling of discomfort comes when the move is at its end. Similarly, notice when an especially profitable position gives you an extra lift in your strut. This is complacency, the silent killer. It is a warning to reassess, if not also to take the opposite position.
Conclusion
Contrarianism is different than simply disagreeing with price action. That’s just cynicism. More accurately, contrarianism at first must understand what is driving price action. Contrarians identify turning points using statistics, observations, and associations. When price already discounts the value perceived by a majority of market participants, then only a minority of market participants will be prepared to enter at the price extreme. Contrarians can always be found among that minority.