There’s one market-timing indicator that beats all others – stupidity. One thing I’ve learned is that you can always bet on the crowd to do the WRONG thing with their money. It’s spooky. Every time a big enough group of people believes the same thing, it turns out to be a load of bullshit. Dot-com stocks . . . the YRK bug . . . the housing bubble. Put simply, crowds are dumb. You can make them do just about anything and follow all sorts of stupid advice.
That’s why being a contrarian investor is so important. A true contrarian sells hysteria and buys despair. History clearly shows this is the one of the only proven ways to make money over the long haul. When prices are high there’s a self-correcting mechanism and when prices are low there’s a self-correcting mechanism. Investors’ perceptions of the future are shaped by their immediate past and they tend to chase high-priced, popular sectors that are set for collapse and they tend to avoid low-priced sectors that are set to soar. Just buying into a sector because it’s unpopular isn’t necessarily a good idea, however. An astute contrarian invests in an unpopular sector that will become popular again.
“You’re either a contrarian or a victim. The choice is yours.” says legendary resources investor, Rick Rule.
Most investors are lazy and choose the easier, less informative method of watching only the stock price – but understanding the price is absolutely useless information if you don’t know what it’s worth. P/E ratios are a good place to start. One simple way to invest like a true contrarian is to keep an eye on sentiment. Sentiment tells you what the crowd is thinking. There are two main types of sentiment indicators. Both are useful signals as to whether investors have become over optimistic…or over pessimistic.
1. The Short Ratio – tells how many investors are short a stock or/and an entire market. That’s how many investors are betting a stock or a market will fall in price (calculated by dividing the short interest by average daily trading volume.) An unusually low short ratio is often a sign of complacency and a signal to sell. An unusually high ratio is a signal to buy.
2. Investor Surveys – a number of surveys record the bullish vs. bearish percentage of investors. One is Investors Intelligence which tells you what percentage of investment advisors are bullish and what percentage are bearish. Another useful measure from Hulbert’s Financial Digest tracks the sentiment of newsletter editors. When newsletter editors are at bullish extremes, it’s time to sell. When they’re at bearish extremes it’s time to buy.
Successful contrarian investors need to do the hard leg work and homework on their investments — and watch the market sentiment.