The Art of Contrarian Trading Part 10

In 1963 an American advisory firm, Investors Intelligence, led by its founding editor A. W. Cohen, began a weekly polling of newsletter writers and other investment advisers about their current stock market views. The results were summarized by the percentages of advisers who were then bullish, bearish, or neutral on the stock market. The Investors Intelligence poll has had many imitators. Some of these have focused on the futures markets. Another is a weekly poll sponsored by the American a.s.sociation of Individual Investors. This is a survey of its members, a much bigger swath of nonprofessional investors, and has been conducted at least since 1987.

Opinion polls like these have a 45-year history. There was a time when I paid a lot of attention to these polls. But I grew disenchanted with them. I found that indications of an ongoing information cascade were far more significant than are the opinions of investment professionals offered on a weekly basis. Moreover, the results of these weekly polls are highly correlated with shorter-term movements in the stock market itself, showing high bullish sentiment after an extended rise in the averages and high bearish sentiment after an extended drop. Consequently, there are no set levels of bullish or bearish sentiment that give reliable clues to the market's subsequent movements.

This is not surprising. These polls are all in the public domain. They make it easy to be a contrarian by, say, turning bullish when 50 percent or more of those polled express bearish views. But the No Free Lunch principle implies that such a strategy cannot beat the market, because it uses information that must already be incorporated into the current level of stock prices.

Why doesn't the same argument imply that the contrarian trader's media diary will similarly be useless? The No Free Lunch principle tells us that any successful contrarian trading strategy must use information that is outside the public's purview. Now, it is true that all the content recorded in a contrarian's media diary is in the public domain. But the diary itself itself is not! The trader's selection of content to retain in his diary will reflect his grasp of the life cycles of investment crowds and his understanding of the types of opinions that reveal an ongoing information cascade. The semiotic interpretation a skilled contrarian makes of his diary material will develop his insight into the nature and intensity of an investment crowd's beliefs. A contrarian trader's media diary thus becomes a highly personalized tool for beating the market and as such is not information available to the investing public. is not! The trader's selection of content to retain in his diary will reflect his grasp of the life cycles of investment crowds and his understanding of the types of opinions that reveal an ongoing information cascade. The semiotic interpretation a skilled contrarian makes of his diary material will develop his insight into the nature and intensity of an investment crowd's beliefs. A contrarian trader's media diary thus becomes a highly personalized tool for beating the market and as such is not information available to the investing public.

Is there any danger that media diaries will become popular among investors who fancy themselves contrarian traders? I think not. First, it is a lot of work to maintain such a diary. Second, acting on the information contained in one's media diary means investing against widely held popular beliefs, something beyond the capacity of most investors. This is the source of the contrarian trader's edge edge.

IS THE ODD LOTTER ALWAYS WRONG?.

In 1941 the first edition of the book New Methods for Profit in the Stock Market New Methods for Profit in the Stock Market was published. Its author, Garfield A. Drew, was asked at the time why he would write a book about stock market profits when there were no profits to be had in the stock market. Drew simply smiled, for he knew that his odd lot indexes were sending a different message. The Dow Jones Industrial Average then was trading near the 105 level, down from its 1929 peak at 381, which had occurred 12 years earlier. The 1929 crash and the Great Depression of the 1930s had soured the nation on the stock market. Yet the April 1942 low in the Dow Jones Industrial Average at the 92 level was then just a few months away, and this average has never again been that low at any time during the subsequent 67 years! was published. Its author, Garfield A. Drew, was asked at the time why he would write a book about stock market profits when there were no profits to be had in the stock market. Drew simply smiled, for he knew that his odd lot indexes were sending a different message. The Dow Jones Industrial Average then was trading near the 105 level, down from its 1929 peak at 381, which had occurred 12 years earlier. The 1929 crash and the Great Depression of the 1930s had soured the nation on the stock market. Yet the April 1942 low in the Dow Jones Industrial Average at the 92 level was then just a few months away, and this average has never again been that low at any time during the subsequent 67 years!

Drew himself was a committed contrarian at a time when the theory of contrary opinion didn't even have a name. The revised 1955 edition of his book sits on my shelf and is of great interest to anyone curious about the historical development of Neill's theory of contrary opinion. Its section VI, ent.i.tled "Measures of Psychology," takes up 68 of the book's 383 pages. In this section Drew explains Neill's work on the theory of contrarian opinion and ill.u.s.trates its use in the stock market during the 1936-1948 period. Drew also explains his particular implementation of Neill's theory, his famous odd lot odd lot indexes. indexes.

Odd lots are orders for less than 100 shares (a round lot round lot) and customarily did not appear on the New York Stock Exchange ticker tape. The ticker tape was a paper-based, telegraphic reporting method for transactions (later was supplanted by the so-called Trans Lux, an electronic version of the paper tape that used to be displayed in all brokerage offices). Nowadays reporting is done electronically on all individual stocks, and no human being could possibly process the torrent of trades if presented to him in the sequence in which they occurred.

In any case, when Drew developed his odd lot indexes it was widely believed that people who traded in odd lots were ill-informed and most p.r.o.ne to be trading on emotions instead of economic fundamentals. But in the late 1930s the Brookings Inst.i.tution published a study of odd lot behavior as shown by monthly transaction totals over the 1920-1938 period. This study concluded that odd lot transactions tended to move toward buying on balance as stock prices declined and toward selling on balance as they advanced. Contrary to the popular conception, odd lotters seemed to act more rationally than the investment advisers polled nowadays by Investors Intelligence: They grew more bullish as prices dropped and less bullish as they advanced!

But Drew had noticed two subtle features that he felt could be used to quantify the then conventional wisdom about odd lot behavior. Near the extremes of price swings, odd lotters would temporarily take leave of their senses! Just before low points occurred, the odd lotters who had been steadily increasing their ratio of purchases to sales would temporarily take fright-one would then observe a temporary decrease in their purchase-sale ratio. Just before high points in the averages, the opposite phenomenon could be observed. Drew also noted that the number of odd lot short sales would often show dramatic and sudden increases near low points of price swings, behavior that is similar to the behavior of the bearish sentiment percentage in investor polls nowadays.

Drew's odd lot indexes represented a significant advance in the theory of contrary opinion. For the first time an objective measure of the market sentiment of a specific segment of the investor population, the odd lotters, had been constructed. This was possible because there was no need for the number of shares purchased in odd lots to equal the number of shares sold. Drew applied his theory with generally good forecasting results until the end of the 1960s. Of course, his odd lot indexes needed a great deal of interpretative skill on Drew's part to be effective.

But in 1973 stock market trading changed dramatically. The Chicago Board Options Exchange was established and spurred the development of exchange trading in put and call options. Now a significant part of the volume of trading on the stock exchanges and options exchanges arose from hedges and spreads, transactions in which traders attempted to profit from mispricing of put and call options. The purchase of a call option can be seen as a bet that a stock will rise in price, whereas the purchase of a put option can be seen as a bet on a price decline. This was both good news and bad news for contrarians.

The bad news was that the advent of exchange-traded put and call options affected the amount of and the motivation for odd lot trading. Where odd lot transactions had previously been investment choices of small investors, now they included a large number of transactions that were part of hedges involving put or call options. At this juncture the odd lot indexes quickly lost most of their value as market clues for the contrarian.

The good news was that now there was a new opportunity to observe the opinions of investors as reflected in the activity of put and call options traded on options exchanges. The theory was that near market lows the ratio of put volume to call volume should be high and the converse should occur near market highs. This put-call ratio has many variants, but they all show strong (negative) correlation with the levels of the stock market averages, just as do the opinion survey numbers. Moreover, the volume of put and call trading is information that is freely available to the public. Consequently, the No Free Lunch principle tells us that these put-call ratios will not be good predictors of subsequent price movements. I believe that this implication has been supported by the evidence.

A FORECASTING GIANT OF THE PAST.

The finest book on speculation ever written is Investment for Appreciation Investment for Appreciation by Lawrence Lee Bazley Angas. First published in 1936, it describes Angas's theory of the business cycle and the steps investors may take to profit from the a.s.sociated swings in the prices of stocks, bonds, and commodities. by Lawrence Lee Bazley Angas. First published in 1936, it describes Angas's theory of the business cycle and the steps investors may take to profit from the a.s.sociated swings in the prices of stocks, bonds, and commodities.

Angas himself developed an extraordinary forecasting record during the 1920-1940 period, when he was invariably right about stock price movements in England and the United States and their a.s.sociated economic fluctuations. In his later years his forecasting record became more erratic. Angas perished in a hotel fire in 1972. A brief biography of the man can be found included in the biography of Neill (Chapter 5 in Five Eminent Contrarians Five Eminent Contrarians) cited earlier in this chapter. As it happened, Neill and Angas had developed a friendship, and in the early 1950s Neill persuaded Angas to move to Neill's hometown of Saxton's River in Vermont.

While it would not do to call Angas a contrarian trader, even a casual reading of his book reveals a man who believed that investment success only comes to those who are willing and able to cross the crowd, to buy when investors are temporarily discouraged and to sell when they are enthusiastic. Angas advocated an investment policy similar to the one that I have suggested for the aggressive contrarian trader-take advantage of shorter-term upswings and downswings that occur in the context of bull and bear markets. In his book Angas also discussed the art of chart reading and advocated its use in conjunction with his economic theories. In fact, he a.s.serted that chart reading by itself was slightly more effective as an investment tool than economics used alone! In any case, a careful look at his chart reading theory shows that it has much in common with the market tabulations I have discussed in Chapter 6 of this book.

PAUL MONTGOMERY, THE MAGAZINE COVER CONTRARIAN.

Paul Macrae Montgomery is the most innovative thinker the world of contrary opinion has seen in the past 40 years. It was from Montgomery that I learned the importance of magazine cover stories for detecting information cascades and the a.s.sociated investment crowds. In the mid-1970s Montgomery studied the Time Time magazine archive containing the covers of all its issues from 1923 to the present. He found that those covers that had some sort of financial market theme often pointed to an imminent top or bottom either in the stock market averages or in the stock of some specific company or industry group. magazine archive containing the covers of all its issues from 1923 to the present. He found that those covers that had some sort of financial market theme often pointed to an imminent top or bottom either in the stock market averages or in the stock of some specific company or industry group.

The general rule he deduced was that bullish or optimistic covers or covers highlighting the success of a prominent CEO or financier generally preceded the development of an important top within the four months subsequent to the cover story. Conversely, covers that conveyed a pessimistic att.i.tude or fear about financial affairs or that highlighted the failure of some prominent financier's policy preceded the development of an important low point within a month.

The pa.s.sing years have been very kind to Montgomery's magazine cover theory. As an active money manager and market commentator, he has used it to make spectacular market calls over the past 30 years. Montgomery stands with Neill, Drew, and A.W. Cohen (the founder of Investors Intelligence) as a guiding light for all contrarian traders.

IRRATIONAL EXUBERANCE AND OTHER BUBBLES.

Bubbles and the crashes that inevitably follow are frequently revived dramas played on the stage of free markets. They are the greatest opportunity and at the same time the greatest danger to the contrarian trader. In this book I have tried to show how monitoring the progress of information cascades can alert the investor to the existence of investment crowds whose growth and disintegration cause bubbles and crashes. And I have shown how to use simple tactics utilizing moving averages of the S&P 500 to time portfolio adjustments suggested by the existence of these cascades.

But the essential nature of any market economy is described by Joseph Schumpeter's wonderful phrase, creative destruction creative destruction. The only thing we can be sure of is that financial markets and the media will be organized differently 50 years from now than they are today. The basic principles of contrarian trading will not change during the next 50 years, if ever. They are timeless and rooted in the nature of free markets. But the specific sources of media content and possibly also the nature and ident.i.ty of the markets most p.r.o.ne to bubbles and crashes probably will evolve in unexpected ways.

To cope with and adjust to changing conditions, the contrarian trader must have a good grasp of the way bubbles and crashes typically develop, a grasp that is attained by studying historical instances of these phenomena. Of course it is better to have lived through and invested during them, but even then a historical perspective reveals details and relationships that are obscure at the time events are unfolding.

I think a good way to start this project is by reading a book ent.i.tled Devil Take the Hindmost Devil Take the Hindmost by Edward Chancellor, subt.i.tled by Edward Chancellor, subt.i.tled A History of Financial Speculation A History of Financial Speculation. This was published in 2000 by the Penguin Group. Sadly, it was written before the stock market bubble of 1994-2000 burst, although it does contain some last-minute comments on this episode on pages 150-151, at the end of the section devoted to the railway mania of the 1830s in England! Among this book's highlights is a long chapter on the boom in the j.a.panese economy during the 1980s and on the subsequent bust.

One of my favorite books is one by David N. Dreman, published in 1977 and ent.i.tled Psychology and the Stock Market Psychology and the Stock Market. Dreman has since become a well-known and very successful money manager and value investor. He also has written a number of other books, but I think this one is his best. In it Dreman explains how Wall Street groupthink feeds stock market bubbles and why no investment professional is immune to its effects. He ill.u.s.trates his thesis with detailed historical accounts of a number of bubbles and a very close look at the U.S. stock market during the 1960s and early 1970s, especially the Nifty Fifty, two-tiered stock market of 1972.

The 1994-2000 stock market bubble in the United States and the subsequent bear market are covered nicely in a book by Maggie Mahar, published in 2003 by HarperCollins and ent.i.tled Bull! Bull! While I like this book, I think it is necessarily incomplete as a historical doc.u.ment since it was published so soon after the bubble burst. Perhaps someone is even now at work on a definitive history of that bubble. While I like this book, I think it is necessarily incomplete as a historical doc.u.ment since it was published so soon after the bubble burst. Perhaps someone is even now at work on a definitive history of that bubble.

Charles P. Kindleberger (1910-2003) was an eminent economic historian. Perhaps his most popular work is the book Manias, Panics, and Crashes Manias, Panics, and Crashes, which was first published in 1978 and most recently in a revised 2005 edition. In this book Kindleberger not only recounts the facts detailing historical episodes of market manias and crashes, but also explains his views on their underlying causes and on the appropriate responses governments should make to these phenomena. This is deeper water than the previous three books I have mentioned, but the reader will be repaid for his effort to navigate in and out of its many historical bays and inlets.

The economist and author with the best literary market timing is without doubt Robert J. Shiller. In March 2000, the exact peak of the 1994-2000 stock market bubble, his book Irrational Exuberance Irrational Exuberance was published by Princeton University Press. In it Shiller argued that only the irrational exuberance of investors could explain the unreasonably high stock market valuations then current. He went on to predict an imminent return to more normal valuations and an attendant substantial drop in stock prices. It should be pointed out that the phrase was published by Princeton University Press. In it Shiller argued that only the irrational exuberance of investors could explain the unreasonably high stock market valuations then current. He went on to predict an imminent return to more normal valuations and an attendant substantial drop in stock prices. It should be pointed out that the phrase irrational exuberance irrational exuberance first entered the public consciousness when Alan Greenspan, the chairman of the Federal Reserve, used it in a speech in 1996. It was Shiller who had suggested this phrase to Greenspan as a description of the stock market psychology of that time. first entered the public consciousness when Alan Greenspan, the chairman of the Federal Reserve, used it in a speech in 1996. It was Shiller who had suggested this phrase to Greenspan as a description of the stock market psychology of that time.

Shiller then repeated this coup of precise publication timing in the 2005 revision of this book, which included an expanded look at and a.n.a.lysis of the bubble in housing prices. The following year saw the peak in housing prices in the United States, and the collapse of this real estate bubble eventually brought on the crash of 2008. In 2008 Shiller published The Subprime Solution The Subprime Solution, in which he presents his a.n.a.lysis of the collapsing real estate bubble and suggests solutions for managing the crisis.

I believe that every contrarian should read and reread both of these books. In them Shiller offers a wealth of information on historical bubbles in stocks and real estate, as well as detailed explanations for the psychological mechanisms that cause them. There can be no doubt that Shiller is the world's reigning expert on the formation of investment crowds, the theme of the book you are reading.

VALUE INVESTING-A BACK-OF-THE-ENVELOPE APPROACH It may seem strange to include a short essay on value investing in a book about speculation. But I think a moment's reflection shows that there is a close connection between value investing and the growth and disintegration of investment crowds. Warren Buffett, the most successful value investor of all time, puts it best when he says that the time to sell is when people are greedy, and the time to buy is when they are fearful. Investment crowds, especially bearish ones, create opportunities for value investors as well as for contrarian traders. So it makes sense that indicators that help value investors determine whether the stock market is far over or far under fair value would be useful to the contrarian trader, too.

A value investor does not pay much attention to crowd psychology. Instead, and above all else, a committed value investor wants to form a reliable estimate of a business's fair value. This generally means trying to determine the rate of return it earns on its invested capital, and whether this rate of return can be sustained and/or improved. A value investor wants to hold shares in companies that earn the highest rate of return on their invested capital, for these are almost by definition the best businesses in the economy. Note that the rate of return earned on invested capital may differ from the rate of return on shareholder equity, because of debt financing. A value investor is generally much more concerned about the former than about the latter, even though both do matter.

Having identified suitable businesses using the rate of return on capital criterion, the value investor then concerns himself with the price at which shares in the business can be purchased. It is at this juncture that value investing becomes as much art as science. What is a fair price for the equity in a good business? There is no definitive answer to this question. One generally seeks guidance from the historical data on valuations of similar companies to estimate some normal range of fair prices for a business with similar characteristics. Intuition, together with business vision, generally plays an important role, too, as does an ability to evaluate whether corporate management is committed to maintaining and improving its rate of return on invested capital.

The formal aspects of this process, those that have to do with balance sheets and income statements, are explained thoroughly in the investment cla.s.sic Security a.n.a.lysis Security a.n.a.lysis by Benjamin Graham and David Dodd. This book was first published in 1934 and is still in print in revised editions. Benjamin Graham is widely acknowledged as the father of value investing and was Warren Buffett's mentor. He is credited with articulating the concept of the margin of safety, which describes the situation in which the market price for a security is sufficiently below its fair value that unforeseen events will not cause loss to the investor. by Benjamin Graham and David Dodd. This book was first published in 1934 and is still in print in revised editions. Benjamin Graham is widely acknowledged as the father of value investing and was Warren Buffett's mentor. He is credited with articulating the concept of the margin of safety, which describes the situation in which the market price for a security is sufficiently below its fair value that unforeseen events will not cause loss to the investor.

An excellent introduction to Benjamin Graham's thinking can be found in his book The Intelligent Investor The Intelligent Investor, which was first published in 1949. I highly recommend the 2006 paperback edition (HarperCollins) containing commentary by Jason Zweig as well as a preface and appendix by Warren Buffett. The story of how Graham's thinking influenced Buffett and of the innovations Buffett made security a.n.a.lysis is told expertly in a wonderful biography, Buffett: The Making of an American Capitalist Buffett: The Making of an American Capitalist, by Roger Lowenstein (Random House, 1995).

Is it easier to be a value investor than a contrarian trader? In a word, no. Both need the ability to stand aside from the crowd's influence, to buy when others are fearful, and to sell when others are cheerful. The value investor's skill in a.s.sessing the likelihood that the rate of return on capital will stay high or improve uses insights that are difficult to teach. Similarly, the contrarian trader's skill in culling suitable media content that accurately reflects the tenor or the time is built only through experience. Both types of investors can carve profitable niches into the slippery slope of the investment mountain. But in neither case is this process easy or simple.

I'd like to offer the interested contrarian three methods that help value investors detect extreme over- or undervaluation in the stock market. These tools need only the back of a handy envelope for calculations. In fact, if you make use of your favorite Internet search engine, you won't even need an envelope. The calculations I am about to describe are often done by dedicated investors who maintain blogs or home pages, and you will probably be able to piggyback yourself on their work.

I should say that you won't be able to become a successful value investor using only these simple methods. They speak only rarely. But when they do they identify situations in which investment crowds have pushed stock market valuations so high or so low that the correct long-term investing stance becomes obvious. This can be very valuable information to a contrarian trader as well.

The first method is simplicity itself. Just calculate the current value of common stocks of publicly traded U.S. corporations and divide this number by the dollar value of gross domestic product (GDP). This stock market/GDP ratio fluctuates above and below its average value of 0.6. In 1929 and 1972, two instances of extreme overvaluation, this ratio stood at 0.8 or higher. In 1932 and 1942, both instances of extreme undervaluation, the ratio stood at 0.2. In 1974 and 1982 the ratio dropped a little below 0.4, showing an undervalued condition that was not as extreme as that a.s.sociated with the Great Depression. At the peak of the 1994-2000 stock market bubble the ratio reached 1.7. My rough calculation shows that the ratio stood near 0.6 in late November 2008, at its historical norm and not showing clear undervaluation.

The second method is similar in spirit to the first. It involves calculating Tobin's q ratio. If you want to learn more about Tobin's q, I suggest you read Valuing Wall Street Valuing Wall Street by Andrew Smithers and Stephen Wright, a book first published in 2000 by McGraw-Hill. Tobin's q is the ratio of the market value of common stocks to the replacement value of the capital employed by the a.s.sociated corporations. This is more difficult to calculate, but the raw data are published by various government agencies. Values of q substantially above 1.0 indicate an overvalued stock market, while values substantially below 1.0 indicate an undervalued stock market. At the peak of the 1994-2000 bubble the q ratio stood at a record high of 2.9. I estimate that on November 20, 2008, with the S&P 500 closing at 752, the q ratio stood at 0.65. While it would need to fall to 0.5 to match the undervaluation levels seen in 1932, 1974, and 1982, the ratio indicated that the U.S. stock market was substantially undervalued in late November 2008. by Andrew Smithers and Stephen Wright, a book first published in 2000 by McGraw-Hill. Tobin's q is the ratio of the market value of common stocks to the replacement value of the capital employed by the a.s.sociated corporations. This is more difficult to calculate, but the raw data are published by various government agencies. Values of q substantially above 1.0 indicate an overvalued stock market, while values substantially below 1.0 indicate an undervalued stock market. At the peak of the 1994-2000 bubble the q ratio stood at a record high of 2.9. I estimate that on November 20, 2008, with the S&P 500 closing at 752, the q ratio stood at 0.65. While it would need to fall to 0.5 to match the undervaluation levels seen in 1932, 1974, and 1982, the ratio indicated that the U.S. stock market was substantially undervalued in late November 2008.

The third method was advocated by Benjamin Graham and popularized in Shiller's book Irrational Exuberance Irrational Exuberance. It is the cla.s.sic price-earnings ratio for the S&P 500, but one that uses the 10-year moving average of reported earnings as the denominator. The average value of this ratio during the past 120 years has been 16. It generally drops below 10 during times of significant undervaluation. By contrast, at the 1929 peak this ratio was over 30, and at the 2000 bubble top it stood at a historical high of 44. At the November 20, 2008, S&P low of 752 this price-earnings ratio stood at 11, well below its historical average but not yet below 10.

These three pages from the value investor's handbook will help the contrarian trader identify the bullish crowds that create stock market bubbles as well as the bearish crowds that seem willing to give away their stock market holdings for a song. Back-of-the-envelope calculations like this won't make you the next Warren Buffett, but they will help you to avoid the mistakes that make stock market investing so frustrating for so many.

About the Author.

Carl Futia is a stock index futures trader with more than 25 years of experience. An economist with a Ph.D. from the University of California at Berkeley, he also has published a number of articles in academic journals. He currently writes one of the most popular investment blogs on the Internet.