It May Be Time to Go Contrarian

by: Bill L.

A wide variety of sentiment surveys have been showing optimism levels at or even above the October 2007 peak in the stock market, meanwhile the masses seem to dismiss these items and instead focus on the continuing flow of bullish headline news. However, experience tells us that running with the herd is profitable only for so long; the time to buy was when there was blood on the streets, and the time to sell is when there is unbridled pervasive optimism. I believe that time is fast approaching.

Bear markets end on bad news, the same way bull markets end on good news. In early March the mainstream media was reporting that the best investment strategy was to sell stocks, and go long guns ‘n ammo, perhaps diversify into some canned food. The exact opposite turned out to be true; that was one of the best buying opportunities in history. Now, the main stream media, is widely reporting the depression has been vanquished in a mere 17 months. A whole 7 months faster than it took to recover from the recession (24 months) and a whopping decade faster than it took to emerge from the Great Depression (29 to 40ish?). While you may argue that this is indeed the start of a new bull market, I’m sure some part of even the most bullish investor’s brain wonders if we have come too-far-too-fast.

There is a fine line in the market that few see, and that is the line between a healthy market and lemmings about to go off a cliff. Breadth indicators such as the NYSE TRIN have now reached its lowest level since October 2007 when the stock market peaked. What this is telling us is that most of the money is flowing into relatively a few issues. Ok so is that a good or bad thing? Well it has been widely reported that most of the daily trading volume in the NYSE is dominated by trading in AIG (NYSE:AIG), Citi (NYSE:C), CIT Group (NYSE:CIT), Fannie Mae (FNM), Freddie Mac (FRE), and a whole host of near bankrupt institutions. Unfortunately, this does not sound like a healthy rational market to me, no it sounds to me more like a gambler who just lost his whole paycheck, and is returning to the table where he just lost with the proceeds from his hocked watch, ready for one last all in.

Now contrarian investing is certainly not an exact science, and I cannot say what day things will suddenly turn around. Furthermore many will see it as subjective, that I am only counting the headlines I wish to see. But when I start see headlines on CNBC to “buy all dips” so the market doesn’t “run away” from you, this is when I get worried. Again, many will argue that I have selective myopia. I contend however that once a strategy becomes so robotic such as “buy all dips,” that is exactly when that strategy will fail in a monumental fashion. Meanwhile we are also starting to see technical evidence that weakness may be creeping into the market. Note the chart below showing a bearish divergence in momentum, failing to confirm the new highs.

To summarize:

  • Headlines: very bullish/optimistic, coast is clear
  • Sentiment: at the prerequisite levels for a huge top
  • Money Managers: buying because of performance anxiety, not value
  • Retail Investor: starting to treat the stock market like a dice game, buying stocks that were it not for Uncle Sam, wouldn’t exist today.
  • Insiders: selling at historic high rates
  • Technicals: failing to confirm new highs
  • Economic Reality: poor, 2nd derivative improvement

If you are bullish, I would opt for cash over the course of the next month or so; to see how this situation resolves itself during this historically weak period. Those who are more aggressive may want to short either the stock market or those stocks that have truly come too far too fast (see my article on Brocade (NASDAQ:BRCD)). But regardless of your long term view of market direction, the technical weakness and lemming optimism should warrant a serious dose of caution to those who are thinking of playing the long side of this market in the near term.

Disclosure: Long SPY Puts, Long BRCD Puts

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