The Contrarian Case

Half of suckerhood is not realizing that
what you don’t like might be loved by
someone else (hence by you, later), and
the reverse.

–Taleb

Veteran traders know the market twists minds: The crowd is still scared silly in the early stages of a bull market. Prices go up slowly. Investors rush for the exits on any rumor or shaky news, causing violent mini-crashes that reinforce the fear, keeping people out.

But the crashes halt above the previous lows, and pretty soon stocks are inching up again. Eventually, years into a great bull market, the crowd catches on to the fact that they should have been buying those little dips. That’s about the time dips start making lower lows.

When stocks start down in a new  bear market, the crowd will hang on because they don’t recognize that the situation has reversed. The market is now inching down, periodically exploding upwards like the 286 point rally in the Dow Jones Industrial Average last Thursday, which soared on the rumor that Greece would get bailed out again. The violent rallies reinforce optimism , keeping people from selling.

I don’t know if we will have new highs again, but, as a trader, I’ve been seeing a change in the day-to-day behavior of the market in the last several months. There is universal agreement on the outlook: it’s rosy. Despite this, the market has been in a trading range since the beginning of December, managing only a couple of modest new highs along the way.

I think this is another time when a big change in direction is in the offing. Investor sentiment is sending the message. Whenever  the data on sentiment reaches extremes of optimism or pessimism, you want to stop doing what everybody else is doing and start thinking about going the other way.

It is not a perfect strategy. The sentiment extremes in 2000 got us out of the market only to see it reverse after a wimpy sell off , come back and make new highs. But sentiment and valuation remained in dangerous territory, so we stayed in cash. The big drop in ’07-09 did generate sentiment that was negative enough to suggest some kind of bottom was in place, but valuations remained high and there was no serious liquidation, so we again stayed put in cash.

What did we miss being out of stocks? From the 2000 top to the present, the market has risen about 50%. The DJI topped around 12,000 back then and is around 18,000 now. That’s about 3.5% a year, not an especially robust move, and the valuations and debt in the system are more extreme by half. Not worth the risk. Statistically, the market is more overvalued and investor sentiment is more outlandishly optimistic than at any time since the British market top in 1720. Paradoxically, the same people, as consumers and workers, are not so sanguine. Cognitive dissonance about their investments, skeptical empiricism about the economy.

I’m looking for a big, big bear market that will result in a major oversold that will look like 1974, when the Dow bottomed at 576. The liquidation was massive and sentiment was the most negative since 1932. Stocks were selling below replacement value. From that oversold period to 2000 the market increased in value by a factor of twenty. Veteran investors that went against the crowd and bought had almost no risk, got terrific dividends and the market made them wealthy. We are waiting for such an occasion.

In 1932 Edward Angly published a small book titled, Oh Yeah? It was a compendium of newspaper headlines, pundit commentary and pronouncements by the nation’s leading bankers and politicians. Everything they said between the secondary top in
April 1930 and the final bottom in ’32 was wrong. Not that they were intentionally lying. They just didn’t know and, in uncertainty, they defaulted to how they felt or how they thought they should feel. They were bravely optimistic in the face of a system that was breaking down and, after the market had lost 89% of its value, they advised people to be prepared for worse.

I expect the same sort of well meaning dissembling to be the order of the day for some time to come. Hence, Cindy and I will disbelieve everything we read or hear about the economy and the market. We will remain in cash until the news and public pronouncements are forecasting total disaster (which will already be the case). That, together with a cheap, cheap, cheap market will entice us to reinvest.

Cheers,

Rod

No one should consider any part of this presentation as a recommendation to buy or sell any securities whatsoever.

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