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The
Contrarian
Principle
One
of the most fascinating theories of market forecasting is
the Contrarian Principle. Simply stated, it is the
concept that the market will generally move in the opposite---or
contrary---direction of the opinion of the majority
of its participants.
For instance, when the overwhelming
majority is optimistic about the market, stocks tend to perform
poorly or even crash. In reverse, when market sentiment is
severely negative, stocks tend to rally.
Some traders swear by this
principle to the extent that an integral part of their strategy
is daily monitoring of “bullish/bearish” sentiment. If the
consensus of stock advisories (analysts, newsletters, stock
sites, etc.) is clearly bullish (positive), they consider
that a bad indicator for the market and act accordingly. When
the same group grows increasingly bearish (negative), they
consider that a positive indicator and will commit to trading.
"I used to believe
that the underlying truth behind the Contrarian
Principle is that most people are wrong about
most things most of the time. I have since learned
that the Contrarian Principle is merely the result
of the market behaving exactly as it should."
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It has been my own personal
experience that the Contrarian Principle works best when the
sentiment, in either direction, has hit extremes. Historically,
a market top is accompanied by extreme, nearly insane optimism.
In the fall of 1999, Allen Greenspan referred to this as “…irrational
exuberance.” Nearly every market crash has occurred during
these highly optimistic levels.
In the other direction, market
bottoms are accompanied by rampant skepticism, doom and gloom.
It has been said by Contarians that the moment it looks like
the market has no bottom, that there is no end in site for
its decline, it has hit bottom or is near its bottom.
I used to believe that the
underlying truth behind the Contrarian Principle is that most
people are wrong about most things most of the time. As tempting
as it might be to buy into this theory, I have since learned
that the Contrarian Principle is merely the result of the
market behaving exactly as it should.
Here is why. Stock prices
are driven up when the demand for the stock is greater than
its supply. Simply stated, there are more buyers than sellers.
Suppose that a stock creates a demand great enough to cause
everyone who intends to get into the market to own this stock.
Yes, the price goes out the roof, except there is now a problem
that didn’t exist before: there isn’t anyone left to buy!
Without any buyers, the stock
has no more momentum to rise. That leaves nothing but sellers,
which in turn causes a chain reaction of more selling and
the stock inevitably crashes.
The entire market goes through
a similar cycle on a broader scale. Once nearly everyone is
“in” the market, there simply isn’t enough new money to sustain
the growth. The market tops out and a long, painful decline
sets in. There simply are not enough new buyers.
It is interesting to note
that prior to a top-out, optimism is inherently at an unprecedented
high. The whole world just had to get in---irrational exuberance.
Such was the fate of the market
in October of 1920, in October of 1987 and in April of 2000.
Optimism was at its peak, stock investing was at an all-time
high and bullish sentiment was rampant.
The same phenomenon occurs
at market bottoms, only in reverse. As the market makes its
decline, more and more people abandon their portfolios and
negative sentiment increases. Eventually, the toughest buy-and-holders
cry “uncle” and throw in the towel as well. By this time,
the bearish sentiment is so overwhelming that nearly everyone
who wanted out of the market is out, which creates an absence
of sellers. That leaves nothing but buyers, hence the market
can finally rally.
These examples are the extreme
cases. I have noticed, however, that the Contrarian Principle
often applies to more subtle, less extreme situations from
week to week. For instance, I distinctly remember reading
several newsletters last August about an inevitable “Post
Labor Day Rally.” Practically every stock advisor believed
that the market would rally following the Labor Day weekend;
many traders and investors alike were lining up the week before,
placing their "bets" for this upcoming, glorious
occasion.
Needless to say, after the
Labor Day weekend, the market sank substantially---the exact
opposite of the popular sentiment.
But what really happened?
Since so many investors were convinced there would be a rally,
they all got “in” before it happened. Once in, there were
not enough investors remaining to drive up the market! From
the Contrarian viewpoint, the market behaved exactly is it
should have.
There are numerous examples
of the Contraian Principle at work, if you look for them.
A couple of weeks ago, while watching “Market Week” on CNBC,
I noticed that six expert analysts made their weekly forecast
for the NASDAQ, and all six predicted that it would rally.
Not surprisingly, the NASDAQ declined the following week.
How could all six professionals be wrong? They weren't, except
their influence probably caused early buying---leading the
way for the sellers.
Although the Contrarian Principle
is best used to forecast market direction, it can also be
applied to individual stocks in certain cases. A stock that
suddenly soars is bound to pull back, not because it has risen
“too high,” but because there aren’t enough new buyers to
sustain its rally. This is a strategy you should consider
when deciding whether or not to take profits on your trade.
If the rally seems almost too good to be true, it probably
is so you should get out. If the stock is that popular it
will run out of buyers.
I generally stay away from
the heavily traded issues for this exact reason. I wonder
if it has ever occurred to anyone that the super popular “big
cap” stocks like Microsoft, Lucent Technologies, etc. skid
into a collective bear market for the simple reason that they
run out of buyers? Highly touted stocks can be dangerous for
this reason.
On the flip side, I love to
pick up stocks after they sell off hard and furious. Once
the volume declines and the price levels out, the sellers
are exhausted (gone). That will leave only buyers and the
stock can rebound. This is a very powerful trading strategy
particularly for stocks that have sold off for no apparent
reason other than rumor and general market sentiment---a classic
Contrarian play.
If a particular stock is unpopular,
I usually take a second look. If a stock is a well-touted
favorite, I stay away. This has approach has served me well
and it is one you should always consider!
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