Reader Nitin pointed to an article in the NYT called “The Crowd Is Restless, but Maybe That’s a Good Sign.”
It deals with contrarian analysis, which simply means that historically the tendency for investors is to be wrong at major turning points. Market tops are reached when there are very few bears left and therefore no money is available on the sidelines to push the market higher.
Conversely, the same happens at the bottom when every bull has thrown in the towel and there is not much selling pressure left. Contrarians follow this approach by focusing on sentiment among investment newsletter editors, who allegedly represent the mood of the average investor.
How can that be?
Very simple. The problem with most newsletter writers is that their views and recommendations are based on their personal “predictions” (some of them short-term) of where the market might be headed. They in essence react as a bunch emotionally no different than the individual investor. The Hulbert Financial Digest has found that the stock market performs better on average after periods when newsletters are bearish rather than when they were bullish.
He argues that currently, the average newsletter editor recommends only a 30.2% allocation to stocks and the balance in cash. This is in contrast to November last year when the Dow was 8% lower, but newsletter editors as groups were recommending an equity exposure of 70.8%. If the theory holds true, the current bull market.
While this maybe interesting, it is not a reliable indicator for use in making buy and sell decisions. Hulbert admits that much and cites several examples. Based on that, it becomes clear that most newsletter advice that is based on predictions is faulty when it counts most.
For example, in early February 2001, the record high bullish sentiment reading was 79.7% after about 1 year into the bear market. Contrarians, who took that as a sell point, were rewarded because the Dow ended up dropping another 33% before the bear ran out of breath. Of course, our Trend Tracking method had us on the sidelines as of October 13, 2000 without having to guess sentiment or making any predictions.
My point is that most newsletters that are based on anything other than tracking cold hard numbers may work well in bull markets, but they’re useless when the bear rears its ugly head.
Comments 2
Hi Ulli,
Contrarians seem to follow the newsletters to gauge the investor sentiment and follow the path exactly opposite to the one that is recommended by them. According to the article, barring few exceptions, they have been succesful.I would not view this as a trend tracking vs contrarian analysis argument. I think it is worth studying whether contrarian analysis based on investor sentiment and trend tracking follow the same trajectory. I do not know whether this is feasible. However, I do feel that we should be open to other approaches and if found useful should not hesitate to incorporate them in our overall strategy.
Nitin
I agree with you, Nitin. I have been following sentiment readings from time to time over the past 20 years. The general direction goes along with trend tracking, but it’s almost impossible to pin down exact turning points.
Just because a contrarian reading is at 70%, does not mean that a turn in market direction is imminent. It simply means that the possibility exists. While that is fine, it’s not a reliable timing indicator.
Overall, contrarian thinking goes along with trend tracking since we trend to buy within 10% of a major bottom and sell within 10% of a major top. Most investors don’t do that. As I mentioned in a recent post, even during the rebound of March 2003, some professional advisors/newsletter writers missed the boat.
I think that’s what the article was referring to: Newsletter writers as a bunch can act emotionally as well and therefore miss out on major market turning points.