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3 Key Tools for the Contrarian Investor - 38820 views
BALTIMORE (Stockpickr) -- It pays to move against the herd -- or at least that’s the idea behind contrarian investing. Being contrarian became an incredibly popular concept in the wake of 2008, when high-profile contrarian bets made some of Wall Street’s most noteworthy market participants billions of dollars richer.
Not surprisingly, as contrarian investing reaches Main Street, would-be practitioners are missing out on some of the finer points of this against-the-grain investment strategy.
In this week’s Technical Primer, let’s take a crash course in contrarian investing.
Contrarian investing is one of the (many) areas in which technical analysis and fundamental analysis intersect. Best described as a component of behavioral finance, contrarian investing focuses on the idea that the herd is wrong -- and more important, that it’s strategically advisable to make a financial bet against conventional wisdom.
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While that’s the working definition that most contrarian investors are familiar with, it’s missing a crucial qualifier. According to the school of thought popularized by Humphrey B. Neill, one of the originators of modern contrarian investing, the key to being successful at this strategy isn’t that the crowd is always wrong. Instead, the crowd is only wrong at turning points.
Real contrarians actually believe that the crowd is right for the majority of a market move.
It’s not until crowd think gets valuations out of whack that contrary bets should be made. That’s an important distinction to make.
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Contrarian investing works because of the psychology of markets during bubbles. As trends become overheated, valuations become overinflated and markets become mispriced relative to normal conditions -- the exact opposite can happen in bear markets.
Markets move in cycles. These cycles are key to how contrary opinion works. Here’s an overview: During the beginning of a trend, buyers are cautious, and the more seasoned players are the primary participants. As the trend gains traction, more and more investors become aware of it, deploying more capital to take advantage of the market’s strength (here’s where the crowd is right). Then at the end of the trend, everyone who’s interested in buying into the trend already had -- with no more available capital to buoy already inflated prices, it’s incredibly easy for a panic to make prices implode (and overcompensate).
Anecdotally, a perfect example of this was the 2008 market crash (and the asset bubble leading up to it, for that matter). Stocks sold off hard, only to regain much of that lost ground in 2009. It wasn’t that corporate America had fundamentally shifted in value that much; rather, it was a case of the crowd dramatically shifting sentiment.
Warren Buffett is famous for sharing a contrarian viewpoint in October 2008, explaining that his personal investing rule is to “be fearful when others are greedy, and be greedy when others are fearful.”
Spotting Turning Points
So, then, if turning points are where the crowd is wrong, the biggest challenge is spotting them. As I see it, there are three tools that are useful for contrarian investing:
If you’re a Buffett-style contrarian, let valuation be your guide. That is to say, step aside when markets get pricey, and become a buyer when stocks look fundamentally cheap. Keep in mind that using valuation as a gauge for contrary opinion can be tough -- not only does it require a strong understanding of fundamental analysis, it also requires its practitioner to attempt to make an objective decision about a subjective topic like “value.”
Looking for deep value plays is most useful at market bottoms, when market prices start to become out of synch with a company’s tangible assets. It’s a whole lot harder to think about real value at tops…
2. Classical Technical Analysis
Another option for contrarians is to use classical technical analysis strategies to spot reversals in the stocks they’re following. On a smaller scale, that can mean looking for a top in a fast-moving momentum trade – on a larger scale, that could mean watching for a trend line break in a major market index.
Ultimately, you’re looking to profit -- or avoid losses -- by taking advantage of the large price move that comes from a mispriced market. Since classic technical strategies are designed to do exactly that, they are extremely useful at both tops and bottoms (even if they tend to be “late” by design).
3. Quantitative and Economic Indicators
The last method skips looking directly at a security’s price, in favor of spotting other factors that could suggest that a trend is looking overblown. Those quantitative factors can include statistical patterns -- such as the “Hindenburg Omen,” which is claimed to predict a stock market crash; market models like extremes in the VIX S&P 500 Volatility Index; and economic metrics such as the Misery Index, which measures economic pain.
These factors allow contrarian investors to act early by taking a contrary position before the market starts to correct itself. That said, caveat emptor -- you can expect a much higher failure rate in overreliance on these numbers. A pragmatic approach to contrarian investing should realistically involve some combination of the three.
Clearly, there’s a whole lot more to being a contrarian investor than always betting against the crowd. Successful contrarians realize that the turning points are key and that the crowd is often right for long periods of time. Hopefully, this crash-course in contrarian investing has increased the chances that you’ll avoid -- and profit from -- the next market crash.
Next time, we’ll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.
In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.
-- Written by Jonas Elmerraji in Baltimore.
Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.