A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks, and understates its prospects for returning to profitability.
Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out. Avoiding investments in over-hyped investments reduces the risk of such drops.
Professionals vs. Non-professionals
“Whenever you find yourself on the side of the majority, it’s time to pause and reflect.” - Mark Twain
What is the “Crowd”? They are the group of not-so-smart institutions, individual investors, traders, speculators, and other players in any market that form a collective opinion that is expressed in the terms of a degree of optimism or pessimism. We will call them the non-professionals.
The professionals are the “smart money”. These are the very few that are aware of crowd behavior and are able to adjust their strategies (long and short) to profit from extreme sentiment. Please note that professional does not mean institution by definition. Most institutions are part of the crowd. The media’s definition of “professional” is not always correct so be aware of the difference.
The key point to make is that when non-professionals display an excessive amount of optimism or pessimism, the professionals enter into the market and drive prices in the opposite position. Any truly non-professional, one-sided opinion or expectation of a market will be unable to anticipate a movement created by the professionals in the opposite direction that is anticipated by the group of non-professionals. This is contrarian investing, going against the masses that believe in only one direction of a market and taking advantage of their unanimous opinion by crushing them on the other side.
How does this work? Some might argue that if everyone’s buying and extremely positive, then why would the market crash? The answer: as more and more investors buy, the market will be almost fully invested. The last ones buying are the ones that bought into the market when the professionals were selling and will be stuck because of this overhead limit. After everyone’s bought, there won’t be anyone left to sustain the buying. Therefore, a fearful panic ensues and the masses start to sell, often times much later than they should have done.
A Recent History of Crowd Behavior: NASDAQ
“You don’t get harmony when everybody sings the same note”. - Doug Floyd
* 12/17/2001 (Brokerage House Strategy) - “2002 - Bring It On: Double-digit earnings growth and benign inflation environment will fuel a 20% gain in the S&P 500 to 1375 by year-end. (Note: the S&P 500 returned -22% at the end of 2002!!!)
* 12/31/2001 (Barron’s) - “The Case of the ‘Super-V’, three stimulating economic factors may come together for 2002″ (Note: There has never been a “V” bottom for bear markets that declined 18 months or longer)
* 1/2/2002 (NY Times) - “The Outlook for Stocks, for investors, 2002 should be better than 2001″ (Note: Still optimistic sentiment holding out in the market)
* 1/2/2002 (WSJ) - “After Two Years of Suffering, Investors Hope for a Rebound” (Note: feelings of depression and hopelessness)
* 12/31/2001 (BusinessWeek) - “Q&A: Still a True Believer in Dow 36,000″. In 2002, the Dow lost another 16.67% and the NASDAQ lost an additional 31.53%. The famous harbinger of this theory is James Glassman. He is 61 and will probably not be able to see his own theory work.
Even towards the bottom, everyone was still optimistic. A bottom cannot form when there is still a divide in sentiment. As the crowd was buying and hoping for a quick rebound, the professionals were still shorting the market the whole way down. The smart money bought toward the end of 2002 when the crowd was bleeding into hopelessness. A technical clue is when the current low is higher than the previous low.
A Perfect Example of a Professional: J. Paul Getty (1892 - 1976)
Billionaire Sir J. Paul Getty said it best in the first chapter of his book How to Be Rich, entitled “How I Made My First Billion”:
“In business, as in politics, it is never easy to go against the beliefs and attitudes held by the majority. The businessman who moves counter to the tide of prevailing opinion must expect to be obstructed, derided and damned. So it was with me when, in the depths of the U.S. economic slump of the 1930s, I resolved to make large-scale purchases and build a self-contained oil business. My friends and acquaintances - to say nothing of my competitors - felt my buying spree would prove to be a fatal mistake.”
In 1962, he was buying when the following headlines were printed in the media:
* “Black Monday Panic on Wall Street”
* “Investors Lose Billions As Market Breaks”
* “Nation Fears New 1929 Debacle”
Shortly afterwards, he mentioned: “I’d be foolish not to buy. Most seasoned investors (Professionals!!!) are doubtless doing much of the same thing. They’re snapping up the fine stock bargains available as a result of the emotionally inspired selling wave.”
He was completely right.
Contrarian Strategies
“The fastest way to succeed is to look as if you’re playing by somebody else’s rules, while quietly playing by your own.” - Michael Konda
* Buy when media headlines read the absolute worst and there is no sentiment divide among investors. Once sentiment becomes entirely pessimistic, buy. Also look out for a bottoming of new capital in flows into stocks. Historically, the good time to buy was when capital in flows were between 10 -15%.
* Sell when everyone is overly bullish and capital in flows into common stock & mutual funds reach a high. (In 1960 the market declined 18%, in 1962 -29%, in 1966 -27%, and in 1968 -37%, while stock ownership levels were between 32- 34%, the highest ever. In 1999-2000, stock ownership levels were at 31-33%, at all time-high)
* Don’t fight the trend. If the primary trend is down, go short. If the primary trend is up, go long. Why fight the long-term direction of the market? Stop trying to be a hero.
* Watch financial networks and read newspapers and magazines to get an idea of where sentiment levels are. Magazine covers are my favorite.
Conclusion
“Follow the path of the unsafe, independent thinker. Expose your ideas to the dangers of controversy. Speak your mind and fear less the label of ‘crackpot’ than the stigma of conformity. And on issues that seem important to you, stand up and be counted at any cost.” - Thomas Watson
It’s safe to say that following the real professionals is the way to go. In order to do that, you have to know how they play. There are three points that need to be stressed:
1) there is tremendous pressure and influence to join the crowd and gain easy acceptance,
2) the crowd is wrong in the majority of times,
3) under duress, psychologically, our emotions and objectivity can become distorted and cause us to rationalize (a dominant coping mechanism) or deny (a dominant defensive mechanism) even the basic realities of truth.
Investors will be able to join the crowd when appropriate, but remain flexible to leave the crowd at times when the market warns us. I encourage each investor to respect the nature of human weakness and to become a free-spirited independent thinker.
.
Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out. Avoiding investments in over-hyped investments reduces the risk of such drops.
Professionals vs. Non-professionals
“Whenever you find yourself on the side of the majority, it’s time to pause and reflect.” - Mark Twain
What is the “Crowd”? They are the group of not-so-smart institutions, individual investors, traders, speculators, and other players in any market that form a collective opinion that is expressed in the terms of a degree of optimism or pessimism. We will call them the non-professionals.
The professionals are the “smart money”. These are the very few that are aware of crowd behavior and are able to adjust their strategies (long and short) to profit from extreme sentiment. Please note that professional does not mean institution by definition. Most institutions are part of the crowd. The media’s definition of “professional” is not always correct so be aware of the difference.
The key point to make is that when non-professionals display an excessive amount of optimism or pessimism, the professionals enter into the market and drive prices in the opposite position. Any truly non-professional, one-sided opinion or expectation of a market will be unable to anticipate a movement created by the professionals in the opposite direction that is anticipated by the group of non-professionals. This is contrarian investing, going against the masses that believe in only one direction of a market and taking advantage of their unanimous opinion by crushing them on the other side.
How does this work? Some might argue that if everyone’s buying and extremely positive, then why would the market crash? The answer: as more and more investors buy, the market will be almost fully invested. The last ones buying are the ones that bought into the market when the professionals were selling and will be stuck because of this overhead limit. After everyone’s bought, there won’t be anyone left to sustain the buying. Therefore, a fearful panic ensues and the masses start to sell, often times much later than they should have done.
A Recent History of Crowd Behavior: NASDAQ
“You don’t get harmony when everybody sings the same note”. - Doug Floyd
* 12/17/2001 (Brokerage House Strategy) - “2002 - Bring It On: Double-digit earnings growth and benign inflation environment will fuel a 20% gain in the S&P 500 to 1375 by year-end. (Note: the S&P 500 returned -22% at the end of 2002!!!)
* 12/31/2001 (Barron’s) - “The Case of the ‘Super-V’, three stimulating economic factors may come together for 2002″ (Note: There has never been a “V” bottom for bear markets that declined 18 months or longer)
* 1/2/2002 (NY Times) - “The Outlook for Stocks, for investors, 2002 should be better than 2001″ (Note: Still optimistic sentiment holding out in the market)
* 1/2/2002 (WSJ) - “After Two Years of Suffering, Investors Hope for a Rebound” (Note: feelings of depression and hopelessness)
* 12/31/2001 (BusinessWeek) - “Q&A: Still a True Believer in Dow 36,000″. In 2002, the Dow lost another 16.67% and the NASDAQ lost an additional 31.53%. The famous harbinger of this theory is James Glassman. He is 61 and will probably not be able to see his own theory work.
Even towards the bottom, everyone was still optimistic. A bottom cannot form when there is still a divide in sentiment. As the crowd was buying and hoping for a quick rebound, the professionals were still shorting the market the whole way down. The smart money bought toward the end of 2002 when the crowd was bleeding into hopelessness. A technical clue is when the current low is higher than the previous low.
A Perfect Example of a Professional: J. Paul Getty (1892 - 1976)
Billionaire Sir J. Paul Getty said it best in the first chapter of his book How to Be Rich, entitled “How I Made My First Billion”:
“In business, as in politics, it is never easy to go against the beliefs and attitudes held by the majority. The businessman who moves counter to the tide of prevailing opinion must expect to be obstructed, derided and damned. So it was with me when, in the depths of the U.S. economic slump of the 1930s, I resolved to make large-scale purchases and build a self-contained oil business. My friends and acquaintances - to say nothing of my competitors - felt my buying spree would prove to be a fatal mistake.”
In 1962, he was buying when the following headlines were printed in the media:
* “Black Monday Panic on Wall Street”
* “Investors Lose Billions As Market Breaks”
* “Nation Fears New 1929 Debacle”
Shortly afterwards, he mentioned: “I’d be foolish not to buy. Most seasoned investors (Professionals!!!) are doubtless doing much of the same thing. They’re snapping up the fine stock bargains available as a result of the emotionally inspired selling wave.”
He was completely right.
Contrarian Strategies
“The fastest way to succeed is to look as if you’re playing by somebody else’s rules, while quietly playing by your own.” - Michael Konda
* Buy when media headlines read the absolute worst and there is no sentiment divide among investors. Once sentiment becomes entirely pessimistic, buy. Also look out for a bottoming of new capital in flows into stocks. Historically, the good time to buy was when capital in flows were between 10 -15%.
* Sell when everyone is overly bullish and capital in flows into common stock & mutual funds reach a high. (In 1960 the market declined 18%, in 1962 -29%, in 1966 -27%, and in 1968 -37%, while stock ownership levels were between 32- 34%, the highest ever. In 1999-2000, stock ownership levels were at 31-33%, at all time-high)
* Don’t fight the trend. If the primary trend is down, go short. If the primary trend is up, go long. Why fight the long-term direction of the market? Stop trying to be a hero.
* Watch financial networks and read newspapers and magazines to get an idea of where sentiment levels are. Magazine covers are my favorite.
Conclusion
“Follow the path of the unsafe, independent thinker. Expose your ideas to the dangers of controversy. Speak your mind and fear less the label of ‘crackpot’ than the stigma of conformity. And on issues that seem important to you, stand up and be counted at any cost.” - Thomas Watson
It’s safe to say that following the real professionals is the way to go. In order to do that, you have to know how they play. There are three points that need to be stressed:
1) there is tremendous pressure and influence to join the crowd and gain easy acceptance,
2) the crowd is wrong in the majority of times,
3) under duress, psychologically, our emotions and objectivity can become distorted and cause us to rationalize (a dominant coping mechanism) or deny (a dominant defensive mechanism) even the basic realities of truth.
Investors will be able to join the crowd when appropriate, but remain flexible to leave the crowd at times when the market warns us. I encourage each investor to respect the nature of human weakness and to become a free-spirited independent thinker.
.
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