The Art of Contrarian Trading Part 5

The Korean War began on June 25, 1950, and the Dow dropped from 224 to 197 over the next three weeks. U.S. ground troops entered Korea on July 1. The 197 low in the Dow has not been seen since.

The Cuban missile crisis occurred in October 1962. In June of that year the Dow ended a 25 percent drop from a high at 734 in December 1961. The June low at 535 was not broken at any time during the missile crisis. The first inkling of Soviet missiles in Cuba reached the U.S. intelligence services in August 1962 with the Dow at 620. The market dropped to a low at 549 on October 24 as the crisis developed. A peaceful resolution was reached on October 28.

The Vietnam War was a different kind of conflict because it had no definite beginning through a declaration of war or start of hostilities. However, it did have a definite end for the United States with the Paris Peace Accords, which were signed on January 27, 1973. The Dow reached a record high close at 1,051 on January 13, 1973, and over the subsequent 23 months dropped nearly 50 percent to a low at 577 in December 1974.

The Watergate scandal forced the resignation of Richard M. Nixon from the presidency of the United States on August 9, 1974. As noted before, the Dow reached its low four months later, and that December low was at essentially the same level as an earlier low on October 10.

The first Gulf War began for the United States in January 1991. Saddam Hussein's Iraq had invaded Kuwait in early August 1990. From its July high in 1990 at the 3,000 level, the Dow dropped to a low at 2,363 on October 11, 1990. Prices never went lower than that even as the United States continued to prepare for war. It was widely expected at the time that the start of shooting would send prices below their October low at 2,363. I appeared on CNBC several times that fall and in early January, and a.s.serted the contrary view that the stock market was about to begin a huge rally. The United States commenced air operations against Iraq on January 15, 1991, with the Dow closing the previous day at 2,482. Over the next six weeks the Dow advanced 20 percent. The Dow has never since been as low at 2,482.

The United States was attacked by terrorists on September 11, 2001. The Dow ended the previous day at 9,605 and the stock market was closed for several days after the attack, reopening on September 17. The Dow continued its drop, reaching a low at 8,235 on September 21. From there the Dow rallied to 10,635 on March 19, 2002.

The second Gulf War began with the invasion of Iraq by U.S. forces on March 20, 2003. The run-up to the war was a confusing time politically in the United States and internationally as opposing political forces debated the merits and dangers of such an invasion. The Dow Industrials reached a low at 7,425 on March 11, and then moved upward to 14,164 on October 9, 2007. Subsequently the average dropped 24 percent by July 2008. It will be interesting to see whether history will record the second Gulf War as being won during the last half of 2007 following the defeat of Al-Qaeda in Iraq. If so, this would be yet another case in which victory or the a.s.surance of victory marked an important top in stock prices.

This historical review should convince you that the threat and the reality of war exert a strong influence of the public's emotions. The emotional turbulence a.s.sociated with war encourages the rapid development and disintegration of investment crowds, and these crowds force markets into valuation mistakes. The frequent market mistakes arising from wartime conditions offer very important opportunities to the contrarian trader.

FINANCIAL CRISES CREATE CROWDS.

Financial crises that attract wide public attention are usually a.s.sociated with the collapse or near collapse of some domestic or foreign financial inst.i.tution or of the credit of some sovereign nation. Most financial crises are of relatively short duration, and as a rule they generate bearish investment crowds. I'd like to briefly review a number of such crises that have occurred during the past 35 years. Note how frequently crises are a.s.sociated with stock market buying opportunities. This happens because the news of the crisis spreads rapidly in the media, as does the fear such news generates. In a matter of days or weeks the a.s.sociated information cascade has persuaded everyone who can be persuaded to join the bearish crowd. The crisis reaches its climax with some sort of government intervention-a guarantee or rescue-and the bearish crowd begins to disintegrate.

There have been a number of financial crises over the past thirty-five years. On June 21, 1970, the Penn Central Corporation defaulted on its commercial paper obligations and declared bankruptcy. This briefly threw the U.S. commercial paper market into turmoil. One should note, however, that a 17-month-long bear market in stock prices had ended just four weeks earlier with the Dow closing at a low of 631 on May 26. It is also interesting to note that the June 1 edition of Time Time magazine featured Federal Reserve chairman Arthur Burns on its cover and was captioned: "Is This Slump Necessary?-Facing an Economy on the Brink." The Dow proceeded to advance to 1,051 on January 11, 1973. magazine featured Federal Reserve chairman Arthur Burns on its cover and was captioned: "Is This Slump Necessary?-Facing an Economy on the Brink." The Dow proceeded to advance to 1,051 on January 11, 1973.

The 1974 low in stock prices developed two months after the resignation of Richard Nixon from the presidency. This was a political crisis, but a weak economy was the subject of Time Time cover stories on September 9 and October 14. The failure of the Franklin National Bank occurred on October 8, and the low point of the S&P 500 index at 62.28 occurred on October 10. The S&P 500 has never since traded as low. cover stories on September 9 and October 14. The failure of the Franklin National Bank occurred on October 8, and the low point of the S&P 500 index at 62.28 occurred on October 10. The S&P 500 has never since traded as low.

On August 12, 1982, Mexico's finance minister informed the U.S. Federal Reserve that Mexico would default on certain short-term debt obligations and that its foreign exchange markets would close the following day. A month earlier the Penn Square Bank had failed in Oklahoma. The Dow Jones Industrial Average reached a low at 777 on August 12, 1982, after dropping from a high at 1,024 in April 1981. The 777 low kicked off a bull market that over the next 25 years carried the Dow to 14,164.

The July-October period of 1998 saw a brief but sharp 20 percent drop in the U.S. stock market averages. On August 17 the Russian government devalued the ruble and defaulted on debt obligations. The resulting turmoil in world debt markets brought a U.S. hedge fund, Long Term Capital Management (LTCM), to the brink of insolvency. Judging the firm too big to fail, the U.S. Federal Reserve organized a takeover of the LTCM portfolio on September 23. One should note that the Dow reached its closing low near 7,530 on August 31 and its intraday low for the year the next day. The Dow then advanced to 11,750 by January 2000.

The last financial crisis I'd like to review is the subprime crisis of 2008. I'll have more to say about this in a later chapter. For now, suffice it to say that the crisis was born of the worldwide housing bubble, which peaked in the United States in 2005. That spectacular advance in housing prices was fueled partly by easy credit and partly by mortgage loans made to borrowers of subprime quality, borrowers who often had insufficient a.s.sets or income. This was only possible because mortgage loans were securitized, bundled together into packages that were in turn sliced and diced into new securities, so-called tranches. The subprime loans were hidden from view behind the complicated mathematical formulas that determined the payouts investors got from each tranche. These formulas depended on financial variables with which no one had any statistical experience, so investor payouts were impossible to predict. Instead, buyers of mortgage securities relied on the ratings that firms like Moody's Investors Service and Standard & Poor's provided for these bonds. Here of course we have a case of the blind being led by the blind. In any event, when large numbers of subprime borrowers began to default on their mortgages, the prices on certain tranches of mortgage securities fell spectacularly. (In late July 2008 Merrill Lynch effectively wrote down mortgage securities with face value of $36 billion by 95 percent!) Even worse, no one in the financial community could be sure which banks or brokerage firms carried such securities (now known as toxic waste) on their books. This effectively froze markets for certain kinds of securities and loans, and the resulting constriction of credit threatened to plunge the United States and the rest of the world into a serious recession or depression.

The stock market consequences of the subprime crisis have not yet been completely recorded as I write this (in November 2008). There have been at least three major government-sponsored rescues of financial inst.i.tutions so far. The first occurred in mid-March 2008 when the brokerage firm of Bear Stearns collapsed and was purchased by JPMorgan Chase. The second occurred in mid-July when mortgage intermediaries Fannie Mae and Freddie Mac were rescued by a Federal Reserve credit guarantee and by a congressional housing rescue package. The third was the rescue on September 16 of the insurance giant, American International Group. But of even more importance was the government decision in mid-September to allow the bankruptcy of the Lehman Brothers investment bank.

The financial crisis a.s.sociated with the panic of 2008 was a significant exception to the historical rule that such crises tend to be brief. Instead of lasting a matter of weeks, just a few months, the panic of 2008 extended through most of the year, and as this is being written in late 2008, it shows no signs yet of abatement. Even so, I think that history will record that the September-November 2008 period, the time when the crisis was most intense and when panic was in the air, was a terrific buying opportunity in the U.S. stock market.

NEW INDUSTRIES AND COMPANIES.

This category is almost self-explanatory. Technological progress and business innovations are constant facts of life in the capitalist economy's Schumpeterian world of creative destruction. New industries arise and new business firms emerge to bring these innovations to market.

Railroads were the speculative darlings of the late 1800s, but industrial firms began to take the reins from the railroads in the early 1900s, a change signaled by the formation of the Standard Oil holding company in 1899 and of U.S. Steel in 1903. During the subsequent two decades the automobile industry grew spectacularly. Led by Ford and General Motors, it changed the economic landscape for business and consumers forever. Radio was the big technological innovation of the 1920s and RCA was the speculative leader of the U.S. stock market of 1929.

Fast-forwarding to the 1960s, we find the computer industry's first incarnation in the form of IBM, the biggest manufacturer of mainframe computers at the time. The pa.s.senger jet led to a rise in airline travel during the same period, and airline stocks were among the growth stocks of the time. In 1980 the birth of the biotechnology industry was heralded by the initial public offering (IPO) of Genentech, a biotechnology firm started in 1976. The biotechnology sector is still rapidly growing today. The 1980s also saw the computer industry's second incarnation with the advent of the personal computer (PC), brought to market by IBM in 1981. Computer software became a growth industry at the same time when Microsoft captured the rights for producing the IBM PC's operating system.

The 1990s witnessed the popularization of the Internet and the rapid development of telecommunications technology in the form of the mobile phone and fiber-optic cable networks. New companies like America Online, Dell Computer, Lucent Technologies, and WorldCom led the stock market upward during those years.

One of the most interesting new companies of the first decade of the new millennium is Google, whose search engine technology dominates the market today and has been used as a device for selling online advertising. Google had its IPO in August 2004 at $85. Three years later Google stock had risen to $747 but it then fell to a low of $247 during the panic of 2008. An interesting thing about Google is that there was a very well-developed bearish bearish crowd at the time of its IPO. This was unprecedented in my experience and let me to take a very bullish stance on Google at the time. You can read the story of Google's IPO in Chapter 14. crowd at the time of its IPO. This was unprecedented in my experience and let me to take a very bullish stance on Google at the time. You can read the story of Google's IPO in Chapter 14.

The investment themes a.s.sociated with new companies and emerging industries are usually bullish themes and project virtually unlimited growth ahead for the company or industry. But the contrarian trader should be careful about being too skeptical about such themes when he first sees them emerge. The fact is that in a big, ever more global economy any new technology or innovation has a lot of potential for growth. Of course no tree grows to the sky, but as we will see in subsequent chapters, the contrarian trader is often wise to join the bullish crowds of these individual companies and industries temporarily. The trick is to stay alert for the spread of the bullish contagion to less attractive and compelling related situations. Once late-coming compet.i.tors arrive on the scene, it is usually time for the contrarian trader to leave the bullish crowd and consider taking a different investment position opposite the crowd's theme.

COMMODITY BOOMS.

Every so often the price of some industrial or agricultural commodity rises dramatically, sometimes to new historical highs, in response to some change in demand or supply conditions. Occasionally several commodities do this simultaneously-a situation that often is a.s.sociated with economy-wide inflation. Big moves in commodity prices often spill over into the stocks of companies a.s.sociated in one way or another with the commodity. These companies may be producers, providers of services or equipment to producers, banks that finance producers, and so on.

The 1972-1974 period saw a dramatic rise in agricultural prices for wheat, corn, soybeans, and related products. Gold went from $35 per ounce to $200 by the end of 1974. In October 1973 the first Arab oil embargo occurred, and by 1974 the price of crude oil had increased fourfold to $13 per barrel. A second though less p.r.o.nounced advance in commodity prices occurred during 1979-1980 and was a.s.sociated with the second oil crisis, which saw the per-barrel price of crude oil rise from $13 to $39. The year 1980 also saw a peak U.S. inflation rate of 13 percent, the highest level of the preceding 30 years and a level not seen since. Accompanying this general inflation was an upward move in gold prices from $100 per ounce in 1975 to $850 in January 1980.

By 1998 the price of crude oil had dropped to $11 and in 1999 gold had declined to the $250 level. From there commodity prices started to move upward, partly in response to growth in emerging economies like India and China and partly in response to liquidity supplied by central banks to cushion the deflation of the stock market bubble during the bear market of 2000-2002. By 2008 agricultural prices had moved well above the high levels last seen in 1973-1974. Gold had moved above $1,000 and crude oil in July 2008 traded at $147.

These spectacular moves in commodity prices have encouraged the development of investment crowds in oil, gold, and various agricultural commodities. My reading of the historical record leads me to believe that we have seen by far the biggest part of the run-up in commodity prices. (This is being written in August 2008.) Over the coming years these markets will remain very volatile even as prices should move downward to more sustainable levels. These adjustments will see the birth and disintegration of many investment crowds in related markets and should provide a wealth of opportunities for the contrarian trader.

INTEREST RATE MOVEMENTS AND THE BOND MARKET.

During the past 30 years the development of new financial instruments, princ.i.p.ally the money market fund and adjustable rate mortgages, has brought the behavior of interest rates and of the bond market to the attention of the general public. This means that the contrarian trader can often identify investment crowds in the bond market, especially after a long move in interest rates upward or downward has occurred.

One contrarian indicator of the stock market boom that properly began in 1982 was the popularity then of money market funds, which were regarded as fail-safe vehicles for a.s.suring a prosperous retirement. In 1982 people had come to believe that annual returns of 10 percent or more on money market accounts were the norm and not the exception. Simultaneously a huge bearish crowd had formed in the bond market. Its theme was that high inflation was a perpetual feature of the economic landscape and that holding long-term bonds was an invitation to capital loss. Long-term bond prices had reached their historical low points in September 1981 and long-term interest rates their corresponding historical highs.

The bearish investment crowd in the bond market was so adamant in its views that in late 1982 I was prompted to publish a bond market prediction. In it I a.s.serted that the 1981 highs in long-term interest rates would not be exceeded for many years to come. I predicted that bond prices would advance and long-term interest rates would fall for 25 to 30 years. In September 1981 the 30-year Treasury bond yielded 15.30 percent, and when I published my prediction the yield was around 11.00 percent. By late 2008 the yield had dropped to 3 percent, the lowest seen in more than fifty years. I think the bullish bond market crowd is about to begin its disintegration. If I am right about this I don't think we will again see treasury bond yields this low during the next thirty years.

USING YOUR MEDIA DIARY TO TRACK INVESTMENT THEMES.

If you faithfully maintain your media diary, it will be a treasure trove of information about the latest popular investment themes. I suggest you try to use the categories I have discussed in this chapter to organize the themes you find in your diary. One way to do this would be write in next to each diary entry the name of the category or the specific theme you think that particular piece of media content reinforces. You may also want to keep a separate index of themes. In such an index you would keep a separate page for each theme you have identified and are following. On this page write in chronological order the date and a very brief description of every diary entry that reinforces the theme. The advantage of this approach is that it will reveal at a glance just how much attention each theme is getting from the media, and this will help you to judge the size and importance of the a.s.sociated investment crowd. You will also find this information helpful in determining the intensity of the crowd's beliefs, and this sort of information is very helpful in determining just where the crowd is in its life cycle.

CHAPTER 10.

Interpreting Your Diary: Market Semiotics Market crowds and information cascades * * the role of the ma.s.s media the role of the ma.s.s media * * your media diary your media diary * * semiotics, the study of signs semiotics, the study of signs * * reading between the lines reading between the lines * * role of the price chart role of the price chart * * Paul Montgomery and magazine cover stories Paul Montgomery and magazine cover stories * Time * Time magazine's cover story marks the end of the bear market magazine's cover story marks the end of the bear market * * read the newspaper read the newspaper * * the importance of headlines the importance of headlines * * front page stories and editorials front page stories and editorials * * crystallizing events crystallizing events * * weighing the evidence weighing the evidence * * more semiotics more semiotics MEDIA AND INFORMATION CASCADES.

Market crowds are built by information cascades. The way to detect a strong or growing market crowd is to observe directly its a.s.sociated information cascade. The amazing thing is that the contrarian trader can do this simply by monitoring the content of the ma.s.s media. The information communicated in a cascade does not flow princ.i.p.ally through private, person-to-person channels. Instead, the ma.s.s media act as the hub of a global communications network that facilitates the communication that sustains an information cascade. Individuals communicate with this media hub (and indirectly with each other) every time they read a newspaper or magazine or connect with the Internet to check the content of their favorite web sites.

Why is this so? Remember that the media are in a never-ending compet.i.tive struggle for readership and for the attendant advertising revenues. To attract readers, the media must provide information and other content that people will find topical, relevant, and interesting. The media are in the business of telling their readers what they want to hear. To survive in this very compet.i.tive environment, the media must have very sensitive antennae tuned to the interests and concerns of their audiences.

From this it follows that the media act as wonderfully reflective mirrors to public opinion. But they play another important role as well. In the process of mirroring public opinion they amplify and focus it by bringing this opinion to the attention of others who don't yet share the consensus view. In other words, the media not only report on the progress of an information cascade, they amplify and strengthen the cascade itself.

YOUR MEDIA DIARY: A LIVING HISTORY OF INFORMATION CASCADES.

Your media diary will serve you as a real-time history of information cascades. Just follow the guidelines I set out for you in Chapters 7 and 8. Be sure to keep your diary up-to-date. As you put new entries into your diary, try to a.s.sociate each one with a specific investment theme. Note the theme of each diary entry in the diary itself or, if you prefer, keep a separate index of themes and the dates and content of the a.s.sociated diary entries. I think you will find that most of your diary entries will be a.s.sociated with the types of themes I discussed in Chapter 9.

If you follow these procedures, your media diary will become a living history of ongoing information cascades in the financial markets. But your diary entries will need further interpretation if they are to help you judge the current strength and stage of development of the a.s.sociated market crowds. This art of interpretation I like to call market semiotics.

SEMIOTICS: THE STUDY OF SIGNS.

What are signs? Probably the first examples of signs that come to mind are the signs we encounter daily when navigating the road to work or when finding our way around an unfamiliar building. These signs often display information in the form of text and/or familiar symbols. Sometimes the symbol is just a color (as with a traffic light) or an arrow pointing in some direction. In general, a sign is something that stands in for or represents something else.

Let's consider the traffic light example a little more carefully. Why is the color red a.s.sociated with the command "stop"? This might simply be a convention that has developed over many years. Any other color could have been a.s.sociated with the command to stop as well. However, one might also suspect that there are physiological reasons for the a.s.sociation of the stop command with the color red. Perhaps the color red is more likely to stand out among the colors typically encountered in nature or in human environments and thus is more likely to attract a person's immediate attention. In any case, the color red has acquired an a.s.sociation with the command "stop" or the warning "danger," even when it appears in completely different contexts-a magazine headline, for example. The color red can now be interpreted as something that stands for the command to stop. But it also has become something more-it has become a sign or the alert for danger.

Semiotics is the study of signs, of things that stand in for or represent other things. Most signs typically have many layers of meaning. The first is the layer holding the obvious content or the intended message of the sign. But there are often deeper, hidden layers of meaning that arise from the sign's use in other contexts.

Let's take a newspaper headline as an example. Suppose we open the morning paper and see a headline that reads, in big block letters, "Stock Market Crash." What are the layers of meaning of this sign? It is is a sign, after all-it is not the stock market itself! The first layer of meaning is contained in the obvious content of the message: The stock market has dropped. A second layer of meaning is conveyed by the use of the word a sign, after all-it is not the stock market itself! The first layer of meaning is contained in the obvious content of the message: The stock market has dropped. A second layer of meaning is conveyed by the use of the word crash crash. This word has a very dramatic and unpleasant connotation a.s.sociated with physical destruction and death. Yet a third layer of meaning arises from the fact that this sign takes the form of a headline. It is the first thing most readers will notice. The newspaper editors must believe this event is important and that it has attracted the attention of their readers and of the general public. Moreover, they must think that even the casual reader's interest will be piqued by the headline. A final layer of meaning is conveyed by the fact that the headline is set in big block lettering. This signifies that the message is even more important than usual and moreover often is a.s.sociated with the presence of some danger.

So we have peeled away at least four different layers of meaning in our hypothetical newspaper headline "Stock Market Crash." You might say that we have read between the lines of this piece of media content. I like to think of semiotics as the art of reading between the lines, of extracting meaning from the form, context, placement, and a.s.sociations of a media message as well as from its superficial content.

Why might it be useful to learn the semiotic art of reading between the lines? Our goal as contrarian traders is to identify market crowds that are near the point of disintegration. It is at this point that the crowd displays extreme mental unity. This unity is a.s.sociated with a h.o.m.ogeneous and heightened emotional state of the crowd's members. Now, most media content purports to convey just the facts. But we need to identify the strength of the emotions hiding behind the facts. It is the strength of these emotions that identifies the point where a market crowd is liable to begin its disintegration.

Here is where the semiotician's skill at interpreting signs and reading between the lines plays a crucial role, for the emotions of a crowd are rarely seen in the substance of the news. Instead they show up, as it were, between the lines, in the deeper layers of meaning conveyed by the content's media placement, the form of the content, a.s.sociated colors and pictures, or choice of descriptive vocabulary, among other clues.

THE MOST IMPORTANT SIGN: THE PRICE CHART.

Let's start with an obvious observation. In life, the "up" direction is a happy one and the "down" direction is a sad one. We want more, not less, of anything we consider good or desirable. The same is true of markets. A stock or stock market average that is advancing in price is making investors happy, but one that is dropping in price is bringing pain to the same investors.

The first sign we look for to help identify a bullish but aging investment crowd is a price chart that shows a dramatic upward trend in prices; the longer and more substantial the advance in prices, the more likely it is that a bullish crowd is nearing its demise. How can we give quant.i.tative meaning to the words longer longer and and more substantial more substantial? In Chapter 6 I offered a method for tabulating a market's historical swings. This method will enable you to identify the approximate time-price zone in which a market is likely to be making a valuation mistake. In all cases, high points will be a.s.sociated with charts showing prices that have been going up for some appreciable amount of time.

Without a bullish-looking price chart, no bullish investment crowd can form. It is the appearance of the price chart-the fact that prices have been advancing significantly and for an appreciable amount of time-that b.u.t.tresses the logic of the information cascade and entices people to join an investment crowd.

Naturally, exactly the same considerations apply to bearish-looking price charts and bearish investment crowds.

These observations may seem obvious, but I cannot overemphasize their importance. The market's price chart and the a.s.sociated historical price tabulations are the starting point of any contrarian a.n.a.lysis you do. Remember that there can be no bear market unless there is first a bull market, and no bull market unless there is first a bear market.

Newcomers to the art of contrarian trading are often confused by the fact that in any market at any point in time there are always some bullish and some bearish voices to be heard, each with its own plausible arguments and rationales. This is only to be expected. After all, if a market is an active one, there must be plenty of buyers and and sellers partic.i.p.ating every day. There are always lots of bears and bulls at hand. The art of contrarian trading requires that you learn how to identify the side of the market that is operating as a crowd, unified in its market rationales and emotions. It is only human nature that this side of the market will be the one a.s.sociated with the most recent, strong, and durable trend in the market price: upward for a bullish crowd and downward for a bearish one. sellers partic.i.p.ating every day. There are always lots of bears and bulls at hand. The art of contrarian trading requires that you learn how to identify the side of the market that is operating as a crowd, unified in its market rationales and emotions. It is only human nature that this side of the market will be the one a.s.sociated with the most recent, strong, and durable trend in the market price: upward for a bullish crowd and downward for a bearish one.

If you keep the semiotic significance of the price chart in mind, you will avoid two very common errors novice contrarian traders make.

The novice's first mistake is to cherry-pick media content that disagrees with his own market view. On this basis the novice can often persuade himself that his market view is a contrarian view, even if his market view in fact makes him part of a growing investment crowd. You are much less likely to make this kind of error if you keep in mind the kind of market chart that is typically a.s.sociated with a bullish or with a bearish investment crowd. The chart is essentially an objective piece of information, at least when seen from a broad-brush, semiotic point of view.

The novice's second mistake is to seize upon a prominent bullish story that appears very early in a bull market or a very prominent bearish story that appears early in a bear market and conclude that the new trend is about to reverse.

The most spectacular instance of this in my memory occurred in August 1982, just as the Dow Industrials began the bull market that would carry this average from 777 to 11,750 by the year 2000. An August 1982 issue of Barron's Barron's weekly had a picture of a rip-snorting bull on its cover. Certain bearish market prognosticators of the time, Joe Granville in particular, interpreted this cover as a sure indicator of an imminent market drop. How wrong they were! And a look at the chart of the Dow would have shown that this contrarian interpretation of the Barron's cover story was wrong-headed. The Dow had been dropping for well over a year and had been turning upward for only three weeks! weekly had a picture of a rip-snorting bull on its cover. Certain bearish market prognosticators of the time, Joe Granville in particular, interpreted this cover as a sure indicator of an imminent market drop. How wrong they were! And a look at the chart of the Dow would have shown that this contrarian interpretation of the Barron's cover story was wrong-headed. The Dow had been dropping for well over a year and had been turning upward for only three weeks!

A second, almost as interesting example of this phenomenon occurred in April 2000, just a month after the very top of the stock market bubble on March 24, 2000. The April 24, 2000, issue of Newsweek Newsweek asked: "Is the Bull Market Really Over?" For reasons evident from other details of the cover, asked: "Is the Bull Market Really Over?" For reasons evident from other details of the cover, Newsweek Newsweek was begging for the answer was begging for the answer yes yes. And it was was over! over!

So cover stories are not always wrong. Sometimes they are eerily prescient. This sort of novice error can be avoided by remembering that a bullish market crowd forms only when the market chart is obviously showing a strong and durable upward trend and the market tabulations described in Chapter 6 warn of potential overvaluation. When the Barron's Barron's cover appeared in 1982, the market charts of the stock averages showed either a bearish or a flat longer-run trend. There had not been time enough and prices had not rallied far enough for a bull market crowd to form. So the experienced contrarian trader had no reason to draw bearish inferences from the cover appeared in 1982, the market charts of the stock averages showed either a bearish or a flat longer-run trend. There had not been time enough and prices had not rallied far enough for a bull market crowd to form. So the experienced contrarian trader had no reason to draw bearish inferences from the Barron's Barron's cover. When the cover. When the Newsweek Newsweek cover appeared, the market chart was still pointing upward. So no bearish crowd could yet have formed, and thus there was no reason for the contrarian traders to draw (long-run) bullish inferences from this cover. cover appeared, the market chart was still pointing upward. So no bearish crowd could yet have formed, and thus there was no reason for the contrarian traders to draw (long-run) bullish inferences from this cover.

MAGAZINE COVER STORIES.

The pioneer in cover story interpretation is Paul Macrae Montgomery. In the 1970s Montgomery originally developed his theory of contrary opinion a.n.a.lysis using the archive of Time Time magazine cover stories. Since then he has expanded upon this very original idea and developed it into a practical theory of the psychological and emotional sources of market fluctuations. I have learned a lot from Paul, and many of my ideas have been inspired by his work. magazine cover stories. Since then he has expanded upon this very original idea and developed it into a practical theory of the psychological and emotional sources of market fluctuations. I have learned a lot from Paul, and many of my ideas have been inspired by his work.

Next to the semiotic interpretation of the market chart, the most convincing piece of evidence that a market crowd is a mature one is an unusual magazine cover story a.s.sociated with the crowd's investment theme. The meaning of the term unusual unusual in this context depends on the source of the media content. For example, it is unusual for in this context depends on the source of the media content. For example, it is unusual for Time Time, Newsweek Newsweek, or other general interest weekly or monthly magazines to publish a cover story a.s.sociate with a financial market. So such cover stories are especially indicative of a mature market crowd. However, Business Week Business Week and and Fortune Fortune both specialize in business and financial news, so financial cover stories in these magazines are not so unusual. The both specialize in business and financial news, so financial cover stories in these magazines are not so unusual. The Economist Economist is more of a general interest magazine than it used to be, but it still emphasizes a business and financial view of world news. is more of a general interest magazine than it used to be, but it still emphasizes a business and financial view of world news.

Note that a magazine cover story might not concern the market directly, but rather an individual closely a.s.sociated with it, for example the CEO of an industry that has been a bull market leader.

An important example of this phenomenon occurred when Time Time made Jeff Bezos, founder of made Jeff Bezos, founder of Amazon.com, it man of the year in December 1999. Bezos personified the new economy theme of the stock market bubble that peaked in March 2000. When interest rates are the focus of a market crowd, the appearance of the chairman of the U.S. Federal Reserve on the cover of Time Time or or Newsweek Newsweek would have special significance. In March 1982 would have special significance. In March 1982 Time Time magazine featured the then Fed chairman, Paul Volcker, on its cover with the caption "Interest Rate Anguish." The bond market was sc.r.a.ping bottom at the time, and long-term interest rates were close to their historical highs (reached on September 30, 1981). That cover marked the start of the disintegration of the bearish bond market crowd. The result was a bull market in bonds and a drop in long-term interest rates that lasted 25 years. magazine featured the then Fed chairman, Paul Volcker, on its cover with the caption "Interest Rate Anguish." The bond market was sc.r.a.ping bottom at the time, and long-term interest rates were close to their historical highs (reached on September 30, 1981). That cover marked the start of the disintegration of the bearish bond market crowd. The result was a bull market in bonds and a drop in long-term interest rates that lasted 25 years.

Magazine covers can be a treasure trove of semiotic information about market crowds. Here is an ill.u.s.tration. My favorite Time Time cover of recent years is its July 29, 2002, cover. This issue hit the newsstands almost on the exact day that the S&P 500 traded at 771. This average then rallied to 965 before dropping to an early October low at 768. The cover itself showed a grandmother on roller skates working as a carhop at a fast-food drive-in. The cover asked: "Will You cover of recent years is its July 29, 2002, cover. This issue hit the newsstands almost on the exact day that the S&P 500 traded at 771. This average then rallied to 965 before dropping to an early October low at 768. The cover itself showed a grandmother on roller skates working as a carhop at a fast-food drive-in. The cover asked: "Will You Ever Ever Be Able to Be Able to Retire Retire?" The subt.i.tle read: "With Stocks Plummeting Stocks Plummeting and Corporations in Disarray, Americans' Financial Futures Are in Peril." (Emphasis is in the original.) and Corporations in Disarray, Americans' Financial Futures Are in Peril." (Emphasis is in the original.) Here is my semiotic a.n.a.lysis of this cover. First, the chart of the market averages was pointing downward. Stock prices had been dropping for almost two and a half years and had fallen nearly 50 percent from their highs. The NASDAQ Composite had fallen nearly 80 percent. My tabular a.n.a.lysis indicated that the market was probably making a mistake of undervaluation, so it was very likely that a strong bearish crowd was at work.

This Time Time cover provided incontrovertible evidence that there was indeed a bearish crowd and that it was in all likelihood a mature one. The cover had several layers of meaning. First, it affirmed that stocks had been plummeting, something that anyone could see from his brokerage statements or from the chart of the averages. It also affirmed that corporations were in disarray because of widespread accounting fraud and pension plan underfunding due to the stock market drop. So this cover was a.s.sociated with two prominent investment themes: the plunging stock market theme and the corrupt corporation theme. cover provided incontrovertible evidence that there was indeed a bearish crowd and that it was in all likelihood a mature one. The cover had several layers of meaning. First, it affirmed that stocks had been plummeting, something that anyone could see from his brokerage statements or from the chart of the averages. It also affirmed that corporations were in disarray because of widespread accounting fraud and pension plan underfunding due to the stock market drop. So this cover was a.s.sociated with two prominent investment themes: the plunging stock market theme and the corrupt corporation theme.

The cover pushed several emotional b.u.t.tons as well. This is a very important aspect of market semiotics. Market crowds have strong emotional attachments to their investment themes. It is this emotional attachment that gives the crowd its mental unity. So when a.n.a.lyzing media content always always pay special attention to the emotional aspects of the message. In the case of this pay special attention to the emotional aspects of the message. In the case of this Time Time cover we notice the use of the word cover we notice the use of the word plummeting plummeting to describe stock prices. Americans' financial futures are in to describe stock prices. Americans' financial futures are in peril peril. Corporations are in disarray disarray. All three words have unusually negative emotional a.s.sociations and connote a situation that is out of control, a time ripe for panic. The cover also plays to the fear all retired or soon-to-retire people have for their financial futures. Will they be able to live out their lives without being reduced to poverty? The cover asks: "Will You Ever Ever Be Able to Be Able to Retire Retire?" It suggests that this is not a good time to retire and that the plummeting stock market has made it likely you will have to work menial jobs for a good part of your retirement to survive. This appeal to a generalized fear for your future is a second and very important emotional b.u.t.ton that this cover pushes. To top this all off, the central character depicted on the cover was granny, a helpless victim of corporate greed and Wall Street malfeasance.

The emotional messages that are this cover's subtext convinced me at the time that this bearish stock market crowd was forcing a mistake of undervaluation. I believed then that a new bull market was just around the corner. The S&P 500 index doubled during the ensuing five years.

NEWSPAPER HEADLINES.

The major metropolitan newspapers are published seven days a week and 52 weeks a year. Every issue contains a lead headline on the front page. Rarely do such headlines concern a financial market. When they do, the contrarian trader sits up and takes notice. Such a headline is convincing evidence of a market crowd at work and of a contrarian trading opportunity at hand.

How does one uncover the emotional content of a headline? The first and most obvious aspect of any headline is its prominence on page 1. Some headlines are confined to the right-hand side of the newspaper and appear only at the top of the a.s.sociated story. Other headlines are spread across the top of page 1 and are for this reason of much more emotional significance. The emotional content of a headline is also emphasized by the type size in which it is printed. Big, bold, block lettering has much more emotional impact than smaller lettering. A headline can also be emphasized by a photograph or a chart appearing near it. The value of this sort of clue cannot be underestimated.

The emotional content of a headline can also be found in the choice of words appearing in its text. Words a.s.sociated with fear, uncertainty, and other negative emotions speak for themselves and should be noted. Words denoting exuberance, confidence, hope, joy, and the like are also significant, though far less common in newspaper headlines. Here are a few recent examples that ill.u.s.trate the application of these principles.

The headline for the January 17, 2008, issue of the New York Times New York Times read: "Fed Chief's Rea.s.surance Fails to Halt Stock Plunge." Let's put this headline in the context of a market chart. The S&P 500 index had reached a high at 1,576 on October 9, 2007, and had dropped as low as 1,364 the previous day, January 16, 2008, for a drop of about 14 percent in three months. According to the market tabulations I discussed in Chapter 6, this was not yet a situation a.s.sociated with an important long-term undervaluation mistake. So the contrarian trader would not have taken this headline as evidence of a mature bear market crowd at work in the stock market. read: "Fed Chief's Rea.s.surance Fails to Halt Stock Plunge." Let's put this headline in the context of a market chart. The S&P 500 index had reached a high at 1,576 on October 9, 2007, and had dropped as low as 1,364 the previous day, January 16, 2008, for a drop of about 14 percent in three months. According to the market tabulations I discussed in Chapter 6, this was not yet a situation a.s.sociated with an important long-term undervaluation mistake. So the contrarian trader would not have taken this headline as evidence of a mature bear market crowd at work in the stock market.

A similar conclusion arises from a semiotic look at the headline. First, the headline was spread over only the first two columns of the newspaper and its type size was not at all unusual for the typical headline. There was some significant emotional content, as can be seen by the use of the word plunge plunge and by a photograph appearing right underneath the story of the Fed chairman as he appeared on TV. The photograph was captioned: "Ben S. Bernanke's face loomed over the Chicago Board of Trade." The use of the word and by a photograph appearing right underneath the story of the Fed chairman as he appeared on TV. The photograph was captioned: "Ben S. Bernanke's face loomed over the Chicago Board of Trade." The use of the word loomed loomed in this context evoked the image of a ghostly, larger-than-life superbeing speaking to his subjects. I note also that the headline states Bernanke's in this context evoked the image of a ghostly, larger-than-life superbeing speaking to his subjects. I note also that the headline states Bernanke's rea.s.surance failed rea.s.surance failed (my emphasis), and this undermines one's confidence in the benevolent powers of this superbeing. (my emphasis), and this undermines one's confidence in the benevolent powers of this superbeing.

Not even a week later, a more dramatic headline appeared. The January 22, 2008, issue of the New York Times New York Times was headlined: "World Markets Plunge on Fears of U.S. Slowdown." It is instructive to compare this headline to the January 17 headline. The January 22 headline was spread across four columns instead of just two. It appeared in larger type. Right underneath the headline were three was headlined: "World Markets Plunge on Fears of U.S. Slowdown." It is instructive to compare this headline to the January 17 headline. The January 22 headline was spread across four columns instead of just two. It appeared in larger type. Right underneath the headline were three color color photographs. The first and largest showed an image of a chart of the Nikkei 225 index for the j.a.panese stock market. It depicted yellow bars on a blue background and showed the average dropping steadily lower. The other two photographs were smaller and showed people around the world reacting to the plunge. The fact that there were photographs a.s.sociated with the headline emphasized its emotional content, and the fact that the photographs were in color doubled this emphasis. photographs. The first and largest showed an image of a chart of the Nikkei 225 index for the j.a.panese stock market. It depicted yellow bars on a blue background and showed the average dropping steadily lower. The other two photographs were smaller and showed people around the world reacting to the plunge. The fact that there were photographs a.s.sociated with the headline emphasized its emotional content, and the fact that the photographs were in color doubled this emphasis.

The next day, January 23, saw another New York Times New York Times headline concerning the stock market. This one was in even bigger and bolder type than the previous day's, although it was spread over only two columns. However, it appeared alongside several graphs, and the entire story was spread across the entire front page. These details all indicated a more powerful emotional state for a bearish stock market crowd than was indicated by the previous day's headline. The January 23 headline read: "Fed, in Surprise, Sets Big Rate Cut to Ease Markets." headline concerning the stock market. This one was in even bigger and bolder type than the previous day's, although it was spread over only two columns. However, it appeared alongside several graphs, and the entire story was spread across the entire front page. These details all indicated a more powerful emotional state for a bearish stock market crowd than was indicated by the previous day's headline. The January 23 headline read: "Fed, in Surprise, Sets Big Rate Cut to Ease Markets."

By January 23 the S&P 500 had dropped 20 percent from its top on October 9, 2007. This put it on the fringe of potential undervaluation according to the price tabulations of Chapter 6, although the drop had lasted only three months, rather a short time for a significant bearish market crowd to form. So the contrarian trader might antic.i.p.ate a relatively short-term bullish trading opportunity here. At the very least he would not be tempted to join the bear crowd by selling stocks at this juncture.

FRONT PAGE STORIES AND EDITORIALS.

Headlines convey very significant information about market crowds to the contrarian trader. But sometime a market-related story appears on the front page of a newspaper without being the headline. Such stories provide additional evidence for the existence and strength of a market crowd, so I make a point of putting them into my market diary, too. The semiotic principles of interpretation are the same as for headlines. The additional bit of information that can be useful concerns the story's placement on the front page: Being close to the top of the page (above the fold is the most significant placement) and positioned to the far left or far right of page 1 increases the weight one should give to the story.

Another source of evidence for market crowds at work can often be found on the first page of the paper's business section. Headlines here, especially if accompanied by photographs, are important material for your diary. However, they do not carry the same weight they would have if they appeared as the headline on the paper's front page.

Very occasionally a general interest newspaper will print an editorial discussing the situation in some financial market. Because this is so unusual I am careful to paste such editorials into my media diary and use them to a.s.sess the strength of market crowds.

CRYSTALLIZING EVENTS.

Very often it will happen that an investment crowd's views will be reinforced and apparently vindicated by some event external to the market itself. The outbreak of war, the signing of a peace treaty, the failure of banks or other financial inst.i.tutions, corporate bankruptcies, and currency devaluations are all examples of such events. I like to think of these events as things that crystallize investor sentiment. They harden beliefs that until then may have been only weakly articulated and defined. As such, crystallizing events are generally a.s.sociated with the imminent disintegration of an investment crowd. I discussed a number of examples of crystallizing events in Chapter 9. Be alert for them as signs that a valuation mistake is being made.

Along the same lines, one should pay special attention to situations in which the media hold out individuals as exemplars of market or business success or failure. During the late 1990s, at the height of the stock market bubble, there was a constant stream of media stories describing in great detail the wealth and lifestyles of the newly minted Silicon Valley millionaires. In 2002, during the depths of the bear market that followed the bubble collapse, most of the bullish a.n.a.lysts who helped inflate the bubble and many of the corporate leaders of collapsed enterprises were pilloried in the media. This was a symptom of stock market undervaluation.

THE WEIGHT OF THE EVIDENCE.

So far I have discussed various methods and approaches for a.n.a.lyzing media content. I have taken the view that this content consists of signs with many layers of meaning. The job of a contrarian trader is to peel away these layers of meaning, always looking for the emotional significance of every sign.

How much media and semiotic evidence must there be before the contrarian trader can be confident that he has identified a market crowd on the verge of disintegration? Is there some mathematical formula or guideline that can be applied to this process to make it more objective, to enable one to weigh the media evidence in some objective manner?

I don't believe there is any simple criterion or formula that can provide reliable answers to these questions. Over the years I have grown more and more skilled at weighing the semiotic evidence only because I have faithfully kept up my media diary. This has given me the opportunity to make comparisons among similar historical market junctures and the intensity and frequency of the media content a.s.sociated with them. So I think the best way to develop the semiotic skills you need for identifying market crowds is to practice. Real-time practice can be reinforced by reading accounts of past bubbles and bear market low points. Such historical information will give you a sense of the conditions and the nature of public opinion a.s.sociated with mature investment crowds.

One might naturally believe that the bigger the valuation mistake, the more pages of one's market diary one will find devoted to the communications of the a.s.sociated market crowd. But there are times when a big valuation mistake is being made by a market crowd even though only a few (but important) media stories appear to confirm it. This was the case at the bottom of the bear market in 2002. There was certainly a general bearish malaise at the time, but only the Time Time magazine cover story in July of that year and a magazine cover story in July of that year and a Newsweek Newsweek August cover story pointed specifically to the market low. So a contrarian trader must be careful not to expect a blizzard of cover stories and/or newspaper headlines to announce the imminent demise of an investment crowd. Sometimes just a few pieces of evidence will do the job, and the volume of evidence is not necessarily correlated with the significance of the opportunity. This is one important reason why contrarian trading is at least as much art as it is science. And an artist's skills require constant practice to develop and maintain. August cover story pointed specifically to the market low. So a contrarian trader must be careful not to expect a blizzard of cover stories and/or newspaper headlines to announce the imminent demise of an investment crowd. Sometimes just a few pieces of evidence will do the job, and the volume of evidence is not necessarily correlated with the significance of the opportunity. This is one important reason why contrarian trading is at least as much art as it is science. And an artist's skills require constant practice to develop and maintain.

MORE ON MARKET SEMIOTICS.

You should not take the guidelines I have offered in this chapter as the last word on the interpretation of your market diary. As the contrarian trader gains experience, his creativity begins to inform his work. Over the years I've made a number of observations about the signs a.s.sociated with market crowds. Here are two examples that have helped me and may well help you in the future.

Consider first the publishing industry. It can provide the contrarian trader with useful clues about the existence of market crowds. I remember back in the late 1970s and early 1980s when bookstores had only one or two shelves devoted to the stock market or investing. By contrast, at the peak of the stock market bubble in 2000 Barnes & n.o.ble had easily 20 or more shelves devoted to the subject of investing. Even more telling, there were very many t.i.tles on subjects like day trading or technical a.n.a.lysis that were not even of interest 20 years earlier. As one might expect, during the eight years subsequent to the 2000 bubble top, the shelf s.p.a.ce devoted to books related to the stock market has shrunk dramatically. This is a very good indicator of declining public interest in the stock market.