It is one thing to understand that going contrary can be profitable. It is quite another to know when to do it. In this article, you will find a few guideposts to point you in the right direction. These guideposts are not found easily; there is no fail-safe way to establish the exact moment when the crowd will be proved wrong. Market prices are determined by the evolving attitudes of individuals who may be either temporarily in or out of the market. The hopes, fears, and expectations of these people and their attitudes toward those expectations are all factored into the price. Trends in psychological attitudes have a tendency to feed on themselves. In many instances, it is possible to point to a market trend that has reached what we might call a normal extreme. The widely held view appears to be well established, and the market seems to have fully discounted this point of view; yet, for some seemingly irrational reason, the movement in crowd psychology continues beyond normal bounds. More and more participants are drawn in and this conventional view becomes increasingly solidified.
Fortunately, these extreme situations, in which normal levels of valuation and rationality are thrown to the wind, do not occur very often. The bull market of the 1920s in the United States and the Japanese equity boom of the 1980s are two such market crazes that readily come to mind. Another example would be the spectacular run-up in precious metal prices that culminated in the 1980 blow off. In each of these examples, rational expectations were abandoned early on and the markets took on a life of their own before the inevitable crash. These situations demonstrate one of the key problems facing the contrarian- calling a market turn too early- in these examples, far too early.
In a way, forming a well-considered contrary opinion is similar to establishing an informal measure of market risk. When all participants agree on a specific outlook, it means that they are all positioned to take advantage of it. In the case of a negative outcome, they will already have sought protection either through a direct sale, by hedging their investment, or a combination of the two. In such instances, the odds are good that the prevailing trend will head in the opposite direction, because there are fewer people to sustain it. In those situations where the trend continues on its course, participants begin to feed on new and freshly developed arguments that help to sustain their belief in the consensus. In extreme cases, these newfound arguments combine with the allure of rapidly moving prices to entice more players onto the field.
When I was a broker in Canada, back in the early 1970s, for example, no one was particularly interested in gold, which was selling for about $100 at the time. Few people understood its role in the monetary system; most were interested in stocks and bonds. By the end of 1979, attitudes had changed. Participation in the gold market had greatly expanded from the usual speculators in the futures markets. Swiss banks had heavily involved their clients, and the public was now queuing up in the banks to purchase the yellow metal. Opinion on gold as an inflationary hedge had not only solidified but had attracted and seduced a naïve pubic into the market as well.
When the question changes from “whether” the price will rise or fall to “when and by how much,” thoughtful people should consider closing out their positions. In the preceding example, that point would probably have been reached when gold was selling in the $300 – $400 range. That, of course, would have been far too early, because the price eventually touched $850. However, the contrarian recognizes that it is far better to be early and right, than late and wrong. Therefore, the major drawback of the contrary approach is that you often find yourself prematurely liquidating a position.
This problem is less critical at market bottoms where values are sound, and prices reverse quickly. When a bearish opinion solidifies, people tend to throw stocks and other investments away at virtually any price. Moreover, sharp price setbacks tend to be self-feeding for a while, since lower prices force those with leveraged positions to liquidate. Fear is a stronger motivator than greed, so the “early” contrarian does not usually have long to wait before prices return to their break-even point. In such situations, he will have the confidence to hold on, since the purchases will undoubtedly be made at an unsustainably low level of valuation. This valuation could take the form of an unusually high dividend yield for stocks, a very high interest rate for bonds, or, in the instance of a commodity, a price that is well below the prevailing level of production costs.
Knowing when to “go contrary” then, is a difficult and elusive task. For this reason, it is best to integrate the contrary approach with other methodologies of market analysis. The degree to which a consensus becomes solidified is, in a sense, a measure of market risk, and what is risky can become more so before the prevailing trend has run its course. Combining the contrary approach with the other approaches, such as, historically accepted measures of valuation can, therefore, represent a useful confirmation. For example, if stocks are yielding less than 3%, interest rates have begun to rise and the view on the street is that stocks have nowhere else to go but up; there is an excellent chance that a major peak in equities is close at hand. When valuations are high, this is another way of saying that the consensus has reached an extreme.
Excerpted from “Investment Psychology Explained”
Related Article: Ingredients for a Mania