Which Contrarians Are Correct About the Stock Market?

When everyone is a contrarian, no one is a contrarian. I consider this a corollary to the famous quote from Humphrey Neill: “When everyone thinks alike, everyone is likely to be wrong” (from a book I really enjoy but inconsistently apply “Art of Contrary Thinking“).

For the past several weeks, I have read and heard all types of conflicting interpretations about market sentiment as different kinds of contrarians attempt to prove their case.

Let’s begin with some of the data:

1. The American Association of Individual Investors recently reported that bullish sentiment is 42%, not an extreme, but part of a steady trend upward from the March lows.
2. The proprietary indicators at sentimenTrader indicate that both short-term and long-term sentiment are bullish and borderline extreme.
3. Short interest is at its lowest level since Februrary, 2007.
4. Insider stock sales peaked in August but remain higher than levels last seen in the second quarter of 2007. Add to this the massive amounts of stock companies are unloading into the market via secondaries and IPOs.

Jon Markman (Markman Capital Insight) recently argued that the Dow will hit 14,000 in two to three years. He dismisses sentiment indicators that include retail investors since they have (relatively) little money at stake. He claims that the “big money” is the dumb money and is extremely pessimistic. He cites a recent Goldman Sachs Group dinner where 14 out of 15 large hedge fund managers concluded stocks are overvalued. (This video explains Markman’s more nuanced perspective: a cyclical bull within a much larger secular bear market).

Finally, we have options expert Bernie Schaeffer who warns that anecdotal sentiment remains very bearish. Schaeffer references institutional money market funds, a survey of macro managers, hedge fund exposure, cash flows into stock mutual funds, and even the above Investor’s Intelligence survey (which was less bullish at the time he wrote) to support his case. He makes an excellent point about the self-reinforcing psychology of major market rallies:

Major stock market rallies have a way of causing bulls to become that much more bullish and bears to become weak and wobbly in their conviction level, as the opinions of the former group are reinforced by market action while the latter group is being regularly beaten up by Mr. Market.

I am sure you can add your own many references to this soup.

As if it is not already difficult enough to sort out the sentiment story, insert the U.S. dollar into this mix. It is now well-recognized that the stock market rally is riding the back of a weak dollar. It now appears that the extremely cheap U.S. dollar is even caught up in the carry trade vortex that puts additional pressure on the currency. All the selling and fresh multi-month lows have generated quite a consensus that the dollar will continue to fall and has encouraged aggressive shorting of the dollar. This bearish sentiment on the dollar should imply bullish sentiment on the stock market given the mechanics of the current carry trade.

So, if market sentiment does indeed remain too skeptical, a contrarian would bet against this crowd but would also bet with the crowds stomping on the dollar’s neck. If market sentiment is actually very bullish, a contrarian would bet against this crowd and bet against the crowd shorting the dollar. I am biased to believe the latter scenario. I am still anticipating a relief rally in the dollar by shorting the British pound (and soon the Canadian dollar). To be consistent, I have to assume that such a rally will be precipitated/accompanied by a significant correction in the stock market. I currently do not think that either counter-trend move will be substantial in duration, just sharp in direction. Of course contrarians in the former camp could always assume that somehow the dollar and the market will finally follow each other higher.

Overall, no matter how we define the sentiment backdrop, it seems to me that as this stock market continues to press onward and upward, more and more people feel most comfortable dressing their opinion, bearish or bullish, in contrarian garb. And I am guilty as charged.

Be careful out there.

Full disclosure: long SSO puts

Comments

[Denis Gould:]

What a fantastic piece. Feels like you are looking into a pair of facing mirrors with your own reflection disappearing into infinity. Not sure about the idea of hedge funds representing the dumb money though. Anybody that can get somebody else to pay them 2 and 20 can't be that dumb.

Maybe the market's evolution from here will be about facts rather than sentiment because the latter is resolutely split. If that is the case then I jump to the bear side because the economic background is highly likely to worsen as stimulus fades. I guess that makes you a little bit more bullish.

Sep 25 04:44 AM

[bbro:]

S&P to GDP now 7.42%.....historical median 9.4%

Sep 25 06:16 AM

[chap08:]

Good article. A few points:

1. Just by the data I use, sentiment suggests a correction soon.
2. Although some of the data readings are overly bullish, I find it hard to reconcile that with what I hear and see around me i.e. I don't see many bullish people.
3. If you look at historical data, sentiment gets "extreme" at the start of bull markets without a huge correction following. It's like other oscillators, it means something different at those times, as opposed to the end of a long bull market. I'm not saying that we're in a bull market, I'm saying that IF we are, then the data does not have much meaning.

Sep 25 06:42 AM

[chap08:]

bbro, I like this ratio. My figures are a little different, but I believe that the thinking is valid. However, to me, this is only meaningful as a long term valuation benchmark, not a short term indicator.


On Sep 25 06:16 AM bbro wrote:

> S&P to GDP now 7.42%.....historical median 9.4%

Sep 25 06:51 AM

[Andrew Butter:]

I agree, a gem.

But remember, "sentiment" doesn't drive the long term, value does.


On Sep 25 04:44 AM Does nobody understand what long term actually means? wrote:

> What a fantastic piece. Feels like you are looking into a pair of
> facing mirrors with your own reflection disappearing into infinity.
> Not sure about the idea of hedge funds representing the dumb money
> though. Anybody that can get somebody else to pay them 2 and 20 can't
> be that dumb.
>
> Maybe the market's evolution from here will be about facts rather
> than sentiment because the latter is resolutely split. If that is
> the case then I jump to the bear side because the economic background
> is highly likely to worsen as stimulus fades. I guess that makes
> you a little bit more bullish.

Sep 25 06:52 AM

[rick12345:]

"Extremely cheap US dollar". Says who ? In my opinion it's still way too high. i.e.. Well over $50 trillion in foreign debt, -3.9% GDP growth, gross debt now running at 100% of GDP, and trade deficits still at $500 billion a year. These are not good numbers for your country my friend. What's more, did someone forget to tell you that the European union is now the largest economy in the world, not the USA. Unemployment in that region is 8.5% compared to 9.7% in the US, so you tell me which economy is poised to grow sooner.

Sep 25 07:10 AM

[chap08:]

I agree that the "weak dollar" is a common misconception. The dollar is still over valued and in the process of adjustment. But people anchor to the past and base their views on America's glory days rather than the reality of today.

However, I wouldn't be so confident about European economy either. Countries like Spain and Ireland are heading in to deflationary spirals. Wait until the German election news has faded and we'll see what stories come out of the banks there too.


On Sep 25 07:10 AM rick12345 wrote:

> "Extremely cheap US dollar". Says who ? In my opinion it's still
> way too high. i.e.. Well over $50 trillion in foreign debt, -3.9%
> GDP growth, gross debt now running at 100% of GDP, and trade deficits
> still at $500 billion a year. These are not good numbers for your
> country my friend. What's more, did someone forget to tell you that
> the European union is now the largest economy in the world, not the
> USA. Unemployment in that region is 8.5% compared to 9.7% in the
> US, so you tell me which economy is poised to grow sooner.

Sep 25 08:17 AM

[aarc:]

We are in the middle of nowhere here as far as the US stock markets and the economy is concerned. That is where severe conflicts do happen among opposing forces.

I would rather be a contrarian when the stock market goes into over-heated or over-extended runs for extended periods of time whether it be to the upside or the downside.

Study the charts of stocks and stock indeces including commodities such as oil.

Over-extended runs tend to reverse in "split-second" timeframes with catastropic or equally forceful reversals that usually exceeds the initial over-heated runs in a much shorter time.

Look at Dow Jones 1920 to 1929 rally and the subsequent 3-year collapse that went below the last low of 1920.

Measure the Chinese indeces run during before they reached their summit in 2008 and their subsequent collapse of more than 72% in a much shorter time.

How about oil? It went over-extended toward $147 without going through the usual process of usual corrections and normal rallies. It over-heated so bad it collapsed back to $33 in a "heartbeat".

Those are the contrarian plays. Not when they are in the middle of nowhere as we are now.

Sep 25 08:19 AM

[enigmaman:]

In my mind it takes three things for a sustainable economic and market recovery to take hold:,DC, Wall Street and main street

Wall Street is gung ho
Main street isnt buying any of it
DC is working in opposition of both

Someone show me one time in history when the USA prospered without the cooperation of all three, just one time!

Sep 25 08:41 AM

[thiazole:]

If you are a contrarian, you need to be contrary to the mindless masses. I think that is part of the problem with why so many "contrarians" missed this rally. They were trying to be contrary to CNBC, or to investor sentiment, or some other "semi"-educated group. There is a time and a place to be contrary to those people (ie, CNBC tends to be overly bullish - it makes sense to be contrary to them at the beginning of a recession when they are going to deny it to the bitter end, but if the recession is ending or has ended, their mindless bullish drivel will actually be correct via broken clock syndrome), but you will rarely be wrong when you are contrary to the mindless masses who know nothing about economics or investing. Back in March, the mindless masses were liquidating their 401Ks. That should have been evidence enough for a contrarian to be doing the opposite. The best place to look at the mindless masses is consumer confidence/sentiment. Is it near the high or near the low? If it is near the low, buying stocks probably makes more sense. If it is near the high, selling might make more sense. If it is halfway between (like right now), then follow the trend. The market has been rising with consumer sentiment, so it will likely continue to rise. When it was halfway between a year ago, but the trend was falling, you should have been following that trend as well by selling the market.

There are rare cases when the mindless masses are correct - in an extended bull market like the late 90s, the masses saw the market going up, and it did. It happens - that is why you can't use one stupid thing (like consumer sentiment) for making investment decisions. It should just be part of the bigger picture.

Sep 25 11:09 AM

[thiazole:]

LOL, the unemployment rate in France and Germany was around 10% BEFORE this recession hit. Growing GDP by adding countries to the union is hardly cause for celebration. We could add all of North and South America and then WE'D have the biggest economy. So what?


On Sep 25 07:10 AM rick12345 wrote:

> "Extremely cheap US dollar". Says who ? In my opinion it's still
> way too high. i.e.. Well over $50 trillion in foreign debt, -3.9%
> GDP growth, gross debt now running at 100% of GDP, and trade deficits
> still at $500 billion a year. These are not good numbers for your
> country my friend. What's more, did someone forget to tell you that
> the European union is now the largest economy in the world, not the
> USA. Unemployment in that region is 8.5% compared to 9.7% in the
> US, so you tell me which economy is poised to grow sooner.

Sep 25 11:15 AM

[proudgrampa:]

I'm thinking about buying some FXE puts. The Euro cannot sustain at that level much longer...

Sep 25 11:26 AM

[bogoMIPs:]

I guess it is a sign of how great this website is, that all kinds of readers pile in to gather and contribute mostly positive thoughts.

However, there are always the usual exceptions; those who come only to detract, or disparage, or to sponge readers like Cetin or to flog their seedy services like KISSA.

Sep 26 12:47 AM

[Dr. Duru:]

Thanks for the kudos and great adds everyone.

And regarding the dollar, yes, I should have said a "weakening", not "weak" dollar.

--- Dr. Duru

On Sep 25 04:44 AM Does nobody understand what long term actually means? wrote:

> What a fantastic piece. Feels like you are looking into a pair of
> facing mirrors with your own reflection disappearing into infinity.
> Not sure about the idea of hedge funds representing the dumb money
> though. Anybody that can get somebody else to pay them 2 and 20 can't
> be that dumb.
>
> Maybe the market's evolution from here will be about facts rather
> than sentiment because the latter is resolutely split. If that is
> the case then I jump to the bear side because the economic background
> is highly likely to worsen as stimulus fades. I guess that makes
> you a little bit more bullish.

Sep 26 01:49 AM

[Ames Tiedeman:]

The market has made a huge move. Those who have said to short it have been wrong for months. With low rates and all this liquidity one would be taking great risk in proclaiming a market top. Is this a massive bear market rally? History says it may indeed be. History is not always correct. Severe caution is advised.

Oct 10 03:09 PM

[JAZZSINGER:]

the whole thing sucks its an insane market up is down down is up though the looking glass

Oct 28 02:20 AM