CHART 29.19 S&P Composite, 1990–2012, and the VIX
Chart 29.20 uses the trendline technique with great effectiveness. This seems to be the best approach because the constant fluctuations of the indicator produce difficulties for moving-average and smoothed momentum techniques. Occasionally, the smoothing approach works very well. However, the results are so erratic that one needs to be very careful in utilizing it.
CHART 29.20 S&P Composite, 2006–2012, and the VIX Showing Trendline Violations
Fundamental Indicators: One of the Best Indications of Sentiment
We saw in Chapter 23 (Chart 23.2) how the Shiller price/earnings ratio has fluctuated in gigantic swings in the last 100 years or so and that these movements were associated with changes in crowd psychology. At major market peaks, investors were willing to pay a huge price for equities, with a P/E generally in excess of 22.5, whereas this investment gauge typically bottomed in the 7 to 8 area. If investors were willing to pay high prices at peaks, it was because they were confident that the good times would continue to roll. On the other hand, fear at secular lows was so pervasive that they demanded bargains at fire sale prices.
We see the same thing with dividend yields, where low yields, less than 3 percent, are tolerated at peaks, but high yields of 6 percent to 7 percent become the order of the day at market bottoms because of the perceived risk and desire to be compensated for it.
Chart 29.21 compares the S&P to an inversely plotted 24-month rate of change (ROC) of the yield. The arrows show that peaks in this momentum indicator usually coincide with those of the market. The action in the mid- to late 1990s shows how optimism, as measured by this particular indicator, reached excessive levels and remained there for an extended period.
CHART 29.21 S&P Composite, 1950–2012, and Inverted Dividend Momentum
A Market’s Reaction to News
Another extremely important, though imprecise, approach to appraisal of market sentiment is to observe the reaction of any market to news events, especially unexpected ones. This is a helpful exercise, since markets look ahead and factor all foreseeable events into the price structure. If a news event that would normally be expected to move the price does not do so, the likelihood is that all the news—good or bad—is already reflected in the price.
A classic example developed at the end of 1988 when the insider stock scandals began to appear, starting with the indictment of Denis Levine and Ivan Boesky. Under normal circumstances, the market would have been expected to sell off. But in this instance, it stalled for a while and then rallied sharply.
The discount rate was raised in the spring of 1978. This should have been a signal to sell, but the market rallied on record volume. In this instance, the fact that new highs quickly outpaced new lows just after a bear market low should have been the technical tip-off that the underlying structure was pretty sound.
Countless examples could be cited for many stocks and markets, but the principle remains that if a price does not respond to news in the expected way, it is probably in the process of turning. Evaluation of this factor is very much a judgment call, but it can act as a useful adjunct to an appraisal of the other technical indicators.
Summary
1. Sentiment indicators are useful supplements to the trend-determining techniques described in other chapters. They should be used for the purpose of assessing the consensus view from which a contrary position can be taken.
2. Since many sentiment indicators are subject to institutional changes, it is mandatory to consider them as a group rather than relying on one or two indicators alone.
Because of the close tie between sentiment and momentum indicators, the latter can be substituted when sentiment data are not available.
30 INTEGRATING CONTRARY OPINION AND TECHNICAL ANALYSIS
“The law of an organized or psychological crowd is mental unity. The individuals composing the crowd lose their conscious personality under the influence of emotion and are ready to act as one, directed by the low crowd intelligence.”
—Thomas Templeton Hoyle
“In any case, regardless of our political leanings, we should remember that the job of a contrarian is to challenge those beliefs that we hold most dear—the very beliefs that, because of our loyalty to them, we are least likely to subject to critical scrutiny.”
—Mark Hulbert, July 25, 2012, MarketWatch
Contrary Opinion Defined
Humphrey Neil put together his own ideas and experience and joined them with the writings of Charles Mackay (Extraordinary Popular Delusions and the Madness of Crowds), Gustav Le Bon (The Crowd), and Gabriel Tarde to form the theory of contrary opinion. Today, it is widely understood that since the “crowd” is wrong at major market turning points, the only game in town is to be a contrarian! Unfortunately, whenever a concept or theory becomes popular, the basic idea is often distorted. This means that those who have taken the theory on its face value and not taken the trouble to study Neil and other writers are probably on shaky ground.
Neil pointed out that the crowd is actually correct for substantial amounts of time. It is at turning points that the majority get things wrong.
This last idea is really the center to Neil’s thinking. Once an opinion is formed, it is imitated by the majority until virtually everyone agrees that it is valid. As Neil (1980) put it, “When everyone thinks alike, everyone is likely to be wrong. When masses of people succumb to an idea, they often run off at a tangent because of their emotions. When people stop to think things through, they are very similar in their decisions.”
The word “think” has been deliberately emphasized because the practice of contrary opinion is very much an art and not a science. To be a true contrarian, you need to study, be patient, be creative, and bring to the table widespread experience. Remember, no two market situations are ever identical because history may repeat, but it rarely repeats exactly. In effect, it’s not as easy as saying, “Everyone else is bearish; therefore, I am bullish.”
Perhaps the best definition of contrary opinion comes from the late John Schultz, who, in a timely bearish article in Barron’s just prior to the 1987 crash wrote, “The guiding light of investment contrarianism is not that the majority view—the conventional, or received wisdom—is always wrong. Rather, it’s that the majority opinion tends to solidify into a dogma while its basic premises begin to lose their original validity and so become progressively more mispriced in the marketplace.”
Three words have been emphasized because they encapsulate the three prerequisites of forming a contrary opinion. First, the original concept solidifies into a dogma. Second, it loses its validity and a new factor or series of factors comes into play. Finally, the crowd moves to an extreme, as reflected in a gross overvaluation. What he is saying is that at the start of a trend a few far-seeing individuals anticipate an alternative scenario or outcome to that being promoted by the majority. Later, as prices rise, others are persuaded that the scenario is valid. Then, as the trend extends, more and more people join the camp, perhaps being persuaded as much by the rising prices as the concept itself. Eventually, the concept or premise becomes a dogma so that everyone accepts it as gospel. By now, though, it has been so well discounted or factored into the price that the security or market in question is way overvalued. Even if the price is not overvalued, the concept begins to lose its original premise and a new scenario emerges. All those betting on the original one lose money as the market reverses to the downside.
These trends occur because investors tend to move as crowds and are subject to herd instincts. If left to their own devices, individuals isolated from their peers would tend to act in a far more rational way. Say, for example, you see stock prices starting to move up sharply after they had already moved up a lot. Even though you might know from your own experience that they cannot continue to go up forever, it would be difficult not to become caught up in the excitement, especially after they had rallied significantly from the level at which you first though
t them irrationally high. Under such an environment it becomes very difficult to think independently from the accepted wisdom of the day.
Major Technical Principle A good contrarian should not go contrary for the sake of going contrary, but should learn to think in reverse, to creatively come up with alternative scenarios to that of the crowd. In other words, try to figure out why the crowd may be wrong.
Why Are Crowds Irrational?
Neil wrote that there are several what he calls social laws that determine crowd psychology. These are as follows:
1. A crowd is subject to instincts that individuals acting independently would never succumb to.
2. People involuntarily follow the impulses of the crowd. (see the later section on why it is difficult to go contrary).
3. Contagion and imitation of the minority make individuals susceptible to suggestion, commands, customs, and emotional appeals.
4. When gathered as a group or crowd, people rarely reason or question, but follow blindly and emotionally what is suggested or asserted to them.
Why then is the crowd wrong at turning points? The reason is that when everyone holds the same bullish opinion, there is very little potential buying power left and very few people left who can perpetuate the trend. By the same token, if the market is mispriced, to quote John Schulz, other investment alternatives are becoming more and more attractive—little wonder that money soon flows from the overvalued, overbelieved situation to the more realistically priced one. The opposite would, of course, be true in a declining trend.
Take, for example, an economy deep in recession, business activity is declining rapidly, and layoffs and high unemployment are getting headlines in the nightly news. Stocks are extending their decline that began over a year ago, and the whole situation appears to be out of control in a self-feeding spiral. While everyone is looking down, it is the prerequisite of the contrarian to look up and ask the question, “What could go right?” This is where the alternative scenario comes in. Remember, people are rational. When they realize that hard times are coming, they adjust their plans accordingly. Businesses will cut excessive inventories, lay off workers, and pay off debts. Once this has been done, break-even points drop and businesses are in a great position to increase profits when the economy turns. All this economizing means that the demand for credit declines and so does its price—interest rates. Falling rates encourage consumers to go out and buy houses, and a new recovery gets underway. As Neil describes it, “In historic financial eras, it has been significant how, when conditions were slumping that, under the pall of discouragement, the underlying economics were righting themselves underneath to the ensuing revival and recovery.”
The same is true in markets. No one is going to hold stocks if they think prices are in for a prolonged decline, so they sell. When all the selling is over, there is only one direction in which prices can go, and that’s up! At that point, true contrarians have decided that enough is enough and that an alternative bullish outcome is likely and the underlying assumptions of the bear market are no longer valid.
Knowing when to go contrary is a key to the whole process because the crowd frequently moves to extremes well ahead of a market turning point. Many professionals knew the situation was getting out of hand in 1928 and in 1999 (for Internet stocks). In both cases, they had concluded that stocks were way overvalued and were discounting the hereafter. These opinions were correct, but their timing was early. Economic trends are often slow to reverse, and manias take prices well beyond reasonable valuations, often to ridiculous and irrational ones. In a sense, crowd psychology can be reflected graphically as a long-term oscillator, such as a rate of change (ROC) that moves to extraordinary levels not seen for decades. In normal times, a market turns when the indicator reaches its overbought level, but on rare occasions, the curve can run up to stratospheric levels. An example is shown in Chart 30.1 for the NASDAQ. The 18-month ROC in the lower panel moves up to a level dwarfing anything seen in the previous 20 years of trading history. Indeed, it was twice as high as the best reading for the S&P Composite in 200 years of history.
CHART 30.1 NASDAQ Composite, 1974–2001, and an 18-Month ROC
If crowd sentiment is reflected in oscillators constructed from the price, then it follows that there are various levels or extremes to which crowds gravitate. The 1999 peak in the NASDAQ, the 1980 top in gold, and the 1929 peak are all examples of an extreme. However, since oscillators can be constructed from daily and weekly data, it follows that forming a contrary opinion is just as valid for shorter-term turning points. The difference is that the mood is not so all encompassing and intense as it is just prior to the bursting of a financial bubble.
Major Technical Principle Major turning points develop when the crowd moves to an overwhelming extreme. Short-term and intermediate-term turning points are associated with less intensive levels of crowd sentiment.
Bearing these comments in mind, it is now time to examine the kinds of signs that indicate when the crowd has moved to an extreme, either for small or large trends, and then see how technical analysis can be applied to such situations.
Why It Is Difficult to Go Contrary
Reading and learning about forming a contrary opinion is one thing, but actually applying it in the marketplace when your money is on the line is completely another. There are several reasons why it is not easy to take a position that is opposite to the majority:
1. It is very challenging for us to take an opposite view from those around us because of our need to conform.
2. If prices are rising sharply and we have already told friends of our reasons for being bearish, we are unlikely to continue in our contrarianism out of a fear of being ridiculed.
3. We often meet hostility when we go against the crowd.
4. There is always a tendency to extrapolate the past, from which we gain a sense of comfort.
5. A certain sense of security can be had from accepting the opinions of “experts” instead of having the confidence to think for ourselves. Chart 30.2 illustrates several quotations that three famous people probably wish they had never made. Never forget that most “experts” have a vested interest in the opinions they give publicly.
CHART 30.2 The S&P Composite, 1921–1935, and Market Comments
6. We tend to believe that the establishment has all the answers. The United States’ entry into Vietnam, the Soviets’ into Afghanistan, and Neville Chamberlain’s famous “peace in our time” speech just before the outbreak of World War II should make us think twice about this assumption.
Three Steps to Forming a Contrary Opinion
1. Figure Out What the Crowd Thinks
The first step is to try and get a fix on the consensus opinion of the market or individual security being monitored. If the crowd is not at an extreme, nothing can be done because we are only concerned with identifying potential trend reversals when crowd psychology has swung sharply in one direction or another. Bear in mind that the crowd is often right during a trend—it’s at the turning point that the herd is almost always wrong. One method of gauging where the majority of market participants lie in their opinion is to refer to the sentiment indicators discussed in the previous chapter, or even an oscillator. Most of the time, these indicators are not telling us very much, but when they reach an extreme, a strong message is being given. Another possibility is to monitor valuations. If they are within the accepted norm, then there is little to be learned, but if they are approaching an extreme, then the crowd is giving us a valuable clue as to the way it is leaning.
Alternatively, a study of the media—particularly the financial media—can inform us of what people are thinking. If there is no clear-cut view, then there is not likely to be an extreme and there is little to be done.
However, as it becomes clear that a general consensus is forming and that consensus is approaching a dogma, it is then time to begin the creative process by thinking in reverse, and that involves the second step.
2. Form Alternative
Scenarios
At this point, we know what the crowd thinks. It is up to us as true contrarians to come up with plausible reasons why it is likely to be wrong. In effect, we have to remove ourselves from the crowd and think in reverse. Such a process involves an understanding of the market we are watching. For example, Chart 30.3 shows the gold market at its secular peak in 1980. At that time, the price had risen from obscurity when it first started to advance in 1968 to being quoted regularly on the nightly news. It seemed to the majority at the end of 1979 that inflation and gold prices would continue to rise forever. However, a realistic contrarian would have realized that the inflation would breed its own deflation as the rising trend of short-term interest rates, driven by rising commodity prices, would cause an economic recession. In addition, the high gold price would attract more mining activity and the adoption of more efficient technologies would enable the mining of higher-cost lodes. Once again, technical analysis can come to our rescue, as Chart 30.3 shows that the 12-month ROC for gold hit a generational extreme. Silver also had a huge run-up in this period from next to nothing to over $50. The talk was of a cornering of the market by Bunker Hunt and other operatives so that it appeared that the sky was the limit. In this instance, the contrarian may have come up with the scenario that a lot of silver had already been mined and was available in the form of silverware, which could easily be melted down and sold as silver bullion. As it turned out, the price was right and the silver market was flooded just at the time when high rates of interest caused margin liquidation in the silver pits.
Technical Analysis Explained Page 44
