There’s a lot of talk about whether investors should be thinking like a contrarian, and that is only for you to decide. There’s so much information on this topic that I could probably write a book, but I will only cover the meat of it. You won’t get my personal bias or opinions, but only facts, backed up with additional support and I hope that this will aid each and every one of you.
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. Note: professional does not mean institution by definition. Most institutions are part of the crowd.
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.
Here’s a “non-professional” diagram I created to illustrate the above point:
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.
The Media’s Portrayal of “Professionals”: An Observation in Barron’s April 28th Issue
This is the “Back in the Pool” issue with the funny-looking bull cartoon testing out the pool’s temperature. Barron’s surveyed “professional” investors and here were some “crowd-like” results:
1) Describe your investment outlook through December 2008:
- Very Bullish: 7%
- Bullish: 43%
- Neutral: 38%
- Bearish: 12%
- Very Bearish: 0%!!!
2) is the
- Overvalued: 10%
- Undervalued: 55%!!!
- Fairly valued: 35%
Here’s a chart of the S&P:
These questions were the biggest eye-poppers:
3) Are you beating the S&P this year professionally?
- Yes: 74%!!!
- No: 22%
4) Personally?
- Yes: 72%!!!
- No: 19%
A Recent History of Crowd Behavior: NASDAQ
“You don't get harmony when everybody sings the same note”. – Doug Floyd
A good way to measure crowd behavior is by paying attention to the media outlets. In 2003, the Elliott Wave Financial Forecast compiled a list of headlines from various financial media outlets on the direction of the 2002 year. Here are a few of the headlines:
And my favorite?
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 Historical Example and Dangers of Crowd Behavior: The Russian MMM Co.
"History never repeats itself, as most people fear. People usually repeat history." – Divine Chikobvu
In 1989, Sergei Mavrodi started MMM
“Has there ever been a society which has died of dissent? Several have died of conformity in our lifetime.” – Jacob Bronowski
Millions of people lost everything they had in the company and it is reported that at least 50 people committed suicide (possibly many more that went unreported). This is an extreme case of following the crowd, but the inherent risks and end results cannot be ignored. Following the crowd can be dangerous!
The Sentiment Cycle: Full of Emotion
“The prevailing attunement is at any given time the condition of our openness for perceiving and dealing with what we encounter; the pitch at which our existence is vibrating. What we call moods, feelings, affects, emotions, and states are the concrete modes in which the possibilities for being open are fulfilled. They are at the same time the modes in which this perceptive openness can be narrowed, distorted, or closed off.” – Medard Boss
Below is a “non-professional” diagram of a typical sentiment cycle (chart patterns vary all the time, so just follow this example, comparable to 1990, for the article):
In the beginning, the professionals have already bought positions near the start of a rally. As more and more people buy, the media, such as the WSJ,
On the first major reversal, investors will not believe that the “strong” rally is over and will continue to hold while bullish sentiment remains at their highs, heralding that this is the time to add new positions. This is the start of the first primary leg of a downtrend. As more continuations occur, fear starts to set in and more non-professionals start selling.
As more and more selling occurs on higher volume, panic and desperation start setting in as investors attempt to 1) breakeven or 2) suffer the smallest loss they can. However, since humans do not like to lose, most will continue to hold waiting for that “bottom ‘round the corner”. Even further selling ensues as at least one more primary leg downward emerges and capitulation occurs on extremely high volume. At this point, everyone is trying to get out at whatever price is available, suffering catastrophic losses and hitting a financial-emotional low.
Next, the money in the market becomes “dead” money” and the market trades in a neutral range for quite some time. On a rally that seems to penetrate above resistance levels a “Wall of Worry” occurs, meaning that investors are wishing and wishing, but aren’t getting what they expect. One last move down occurs to entirely wash out the weak hands and purging the market of weakness before the market is able to start a strong uptrend.
The moment the rally passes all resistance points within the neutral trading range, denial forms and investors miss the boat since they got burned so many times before. Think of it as a child that fed an angry dog and got bitten, and never fed a dog again. Now the professionals are ready to enter once a higher low and higher high is achieved. Thus, the rally strengthens and more money comes into play, creating a feeling of hope and optimism and later, returned confidence for the cycle to start back all over again.
Once a break in the uptrend occurs, usually by the 200-day MA and less so with the 50-day MA, a prudent investor is advised to sell all long positions without hesitation (if you’re wrong, you can always buy back, so don’t worry about “missing out”, but worry about getting crushed!). The most significant break this year occurred on the first trading day of 2008. Once the reversal takes place, there is no stopping it as the market must purge the excesses of the previous rally and sellers become more and more willing to sell at whatever price is offered to them. If an investor keeps in mind all the emotions that take place within the cycle, he/she will be positioned with the professionals, and that’s who we want to be with.
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.
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%, near an 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 I stress: 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. Good luck!
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