The Art of Contrarian Investing: Going Against the Crowd for Profit

A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding investments in over-hyped investments reduces the risk of such drops. – Wikipedia

There’s a lot of talk about whether investors should think like contrarians, and that is only for you to decide. There’s so much information on this topic that I could probably write a book, but I will only cover the meat of it. You won’t get my personal bias or opinions, but only facts, backed up with additional support and I hope that this will aid each and every one of you.

Professionals vs. Non-professionals 

"Whenever you find yourself on the side of the majority, it's time to pause and reflect."  – Mark Twain

What is the “Crowd”? It is the group of not-so-smart institutions, individual investors, traders, speculators, and other players in any market that form a collective opinion that is expressed in the terms of a degree of optimism or pessimism. We will call them the non-professionals.

The professionals are the “smart money”. These are the very few  that are aware of crowd behavior and are able to adjust their strategies (long and short) to profit from extreme sentiment. Note: professional does not mean institution by definition. Most institutions are part of the crowd.

The key point to make is that when non-professionals display an excessive amount of optimism or pessimism, the professionals enter into the market and drive prices in the opposite position. Any truly non-professional, one-sided opinion or expectation of a market will be unable to anticipate a movement created by the professionals in the opposite direction that is anticipated by the group of non-professionals. This is contrarian investing, going against the masses that believe in only one direction of a market and taking advantage of their unanimous opinion by crushing them on the other side.

Here’s a “non-professional” diagram I created to illustrate the above point:

 

How does this work? Some might argue that if everyone’s buying and extremely positive, then why would the market crash? The answer: as more and more investors buy, the market will be almost fully invested. The last ones buying are the ones that bought into the market when the professionals were selling and will be stuck because of this overhead limit. After everyone’s bought, there won’t be anyone left to sustain the buying. Therefore, a fearful panic ensues and the masses start to sell, often times much later than they should have done.

A recent example of massive cash inflow (totaling hundreds of billions of dollars) is shown below. Note that the peak of the NASDAQ was on March 10, 2000 at 5,132.52 at nearly the same time when the largest monthly in flow occurred. Clearly, everyone was as invested at the full limit.

 

The Media’s Portrayal of “Professionals”: An Observation in Barron’s April 28^th Issue

This is the “Back in the Pool” issue with the funny-looking bull cartoon testing out the pool’s temperature. Barron’s surveyed “professional” investors and here were some “crowd-like” results:

1) Describe your investment outlook through December 2008:

• Very Bullish: 7%
• Bullish: 43%
• Neutral: 38%
• Bearish: 12%
• Very Bearish: 0%!!!

2) Is the U.S. stock market overvalued, undervalued, or fairly valued at current levels?

• Overvalued: 10%
• Undervalued: 55%!!!
• Fairly valued: 35%

Here’s a chart of the S&P:

These questions were the biggest eye-poppers:

3) Are you beating the S&P this year professionally?

• Yes: 74%!!!
• No: 22%

3) Personally?

• Yes: 72%!!!
• No: 19%

First of all, how can 3/4^th of money managers be beating the market in a bear market? Many MM’s obviously “misstated” their performance before the time of publication because we all know that most money managers follow or perform similar with the index, and the index was negative at that time (YTD 2008) and 2) I’m sure the responses have changed since then (I’d like to see a revised poll). Perhaps they don’t know the characteristics of a bear market? The media’s definition of “professional” is not always correct so please be aware of the difference. 

A Recent History of Crowd Behavior: NASDAQ

“You don't get harmony when everybody sings the same note”. – Doug Floyd

A good way to measure crowd behavior is by paying attention to the media outlets. In 2003, the Elliott Wave Financial Forecast compiled a list of headlines from various financial media outlets on the direction of the 2002 year. Here are a few of the headlines:

• 12/17/2001 (Brokerage House Strategy) – “2002 - Bring It On: Double-digit earnings growth and benign inflation environment will fuel a 20% gain in the S&P 500 to 1375 by year-end." (Note: the S&P 500 returned -22% at the end of 2002!!!)
• 12/31/2001 (Barron’s) – “The Case of the ‘Super-V’, three stimulating economic factors may come together for 2002.” (Note: There has never been a “V” bottom for bear markets that declined 18 months or longer.)
• 1/2/2002 (NY Times) – “The Outlook for Stocks, for investors, 2002 should be better than 2001.” (Note: Still optimistic sentiment holding out in the market.)
• 1/2/2002 (WSJ) – “After Two Years of Suffering, Investors Hope for a Rebound.” (Note: Feelings of depression and hopelessness.)

And my favorite? 12/31/2001 (BusinessWeek) – “Q&A: Still a True Believer in Dow 36,000”. In 2002, the Dow lost another 16.67% and the NASDAQ lost an additional 31.53%. The famous harbinger of this theory is James Glassman. He is 61 and will probably not be able to see his own theory work.

Even towards the bottom, everyone was still optimistic. A bottom cannot form when there is still a divide in sentiment. As the crowd was buying and hoping for a quick rebound, the professionals were still shorting the market the whole way down. The smart money bought toward the end of 2002 when the crowd was bleeding into hopelessness. A technical clue is when the current low is higher than the previous low.

A Historical Example and Dangers of Crowd Behavior: The Russian MMM Co.

"History never repeats itself, as most people fear. People usually repeat history." – Divine Chikobvu

In 1989, Sergei Mavrodi started MMM (not to be confused with 3M Co.). Stock was first issued in February 1994 at $1.00 a pop and rose to $65 by mid-July after Sergei spent millions in TV and newspaper ads promising returns of 1,000%, gaining an estimated 5 million shareholders at its peak. In mid-1994, the Russian government began investigating MMM and found that there was no business behind the business, crushing the stock from $60 to $0.46.

At this point, Investors were desperately trying to redeem their stock at whatever price they could get. However, Sergei claimed that MMM was releasing new products that would become popular overnight and offered to redeem shares at $50. At an instant, investors who were once desperate bought more shares of MMM propping the stock back up near its highs. MMM owned between $50 million - $1.5 billion USD in taxes and closed down, bankrupt, in September 1997. MMM’s slogan: “Flying from shadow to the light”. It’s more like “Flying from the shadow to the abyss”.  

“Has there ever been a society which has died of dissent? Several have died of conformity in our lifetime.” – Jacob Bronowski

Millions of people lost everything they had in the company and it is reported that at least 50 people committed suicide (possibly many more that went unreported). This is an extreme case of following the crowd, but the inherent risks and end results cannot be ignored. Following the crowd can be dangerous!

The Sentiment Cycle: Full of Emotion

“The prevailing attunement is at any given time the condition of our openness for perceiving and dealing with what we encounter; the pitch at which our existence is vibrating. What we call moods, feelings, affects, emotions, and states are the concrete modes in which the possibilities for being open are fulfilled. They are at the same time the modes in which this perceptive openness can be narrowed, distorted, or closed off.” – Medard Boss

Below is a “non-professional” diagram of a typical sentiment cycle (chart patterns vary all the time, so just follow this example, comparable to 1990, for the article):

 

In the beginning, the professionals have already bought positions near the start of a rally.  As more and more people buy, the media, such as the WSJ, CNBC, Barron’s, Bloomberg, etc. profile that particular market or security. As this happens, now everyone knows about the hottest thing in the market, and now they start to buy up en masse. This creates enthusiasm and confidence and shortly later, greed and possible delusion at the top. The professionals sell here and on a technical level, this represents the classic, parabolic unsustainable uptrend (i.e. Corn and Wheat).

On the first major reversal, investors will not believe that the “strong” rally is over and will continue to hold while bullish sentiment remains at their highs, heralding that this is the time to add new positions. This is the start of the first primary leg of a downtrend. As more continuations occur, fear starts to set in and more non-professionals start selling.

As more and more selling occurs on higher volume, panic and desperation start setting in as investors attempt to 1) breakeven or 2) suffer the smallest loss they can. However, since humans do not like to lose, most will continue to hold waiting for that “bottom ‘round the corner”. Even further selling ensues as at least one more primary leg downward emerges and capitulation occurs on extremely high volume. At this point, everyone is trying to get out at whatever price is available, suffering catastrophic losses and hitting a financial-emotional low.

Next, the money in the market becomes “dead” money” and the market trades in a neutral range for quite some time. On a rally that seems to penetrate above resistance levels a “Wall of Worry” occurs, meaning that investors are wishing and wishing, but aren’t getting what they expect. One last move down occurs to entirely wash out the weak hands and purging the market of weakness before the market is able to start a strong uptrend.

The moment the rally passes all resistance points within the neutral trading range, denial forms and investors miss the boat since they got burned so many times before. Think of it as a child that fed an angry dog and got bitten, and never fed a dog again. Now the professionals are ready to enter once a higher low and higher high is achieved. Thus, the rally strengthens and more money comes into play, creating a feeling of hope and optimism and later, returned confidence for the cycle to start back all over again.

Once a break in the uptrend occurs, usually by the 200-day MA and less so with the 50-day MA, a prudent investor is advised to sell all long positions without hesitation (if you’re wrong, you can always buy back, so don’t worry about “missing out”, but worry about getting crushed!). The most significant break this year occurred on the first trading day of 2008. Once the reversal takes place, there is no stopping it as the market must purge the excesses of the previous rally and sellers become more and more willing to sell at whatever price is offered to them. If an investor keeps in mind all the emotions that take place within the cycle, he/she will be positioned with the professionals, and that’s who we want to be with. 

A Perfect Example of a Professional: J. Paul Getty (1892 – 1976)

Billionaire Sir J. Paul Getty said it best in the first chapter of his book How to Be Rich, entitled “How I Made My First Billion”:

“In business, as in politics, it is never easy to go against the beliefs and attitudes held by the majority. The businessman who moves counter to the tide of prevailing opinion must expect to be obstructed, derided and damned. So it was with me when, in the depths of the U.S. economic slump of the 1930s, I resolved to make large-scale purchases and build a self-contained oil business. My friends and acquaintances – to say nothing of my competitors – felt my buying spree would prove to be a fatal mistake.”

In 1962, he was buying when the following headlines were printed in the media:

• “Black Monday Panic on Wall Street”
• “Investors Lose Billions As Market Breaks”
• “Nation Fears New 1929 Debacle”

Shortly afterwards, he mentioned: “I’d be foolish not to buy. Most seasoned investors (Professionals!!!) are doubtless doing much of the same thing. They’re snapping up the fine stock bargains available as a result of the emotionally inspired selling wave.”

He was completely right.

Contrarian Strategies

"The fastest way to succeed is to look as if you're playing by somebody else's rules, while quietly playing by your own.”– Michael Konda

• Buy when media headlines read the absolute worst and there is no sentiment divide among investors. Once sentiment becomes entirely pessimistic, buy. Also look out for a bottoming of new capital in flows into stocks. Historically, the good time to buy was when capital in flows were between 10 -15%.
• Sell when everyone is overly bullish and capital in flows into common stock & mutual funds reach a high. (In 1960 the market declined 18%, in 1962 -29%, in 1966 -27%, and in 1968 -37%, while stock ownership levels were between 32- 34%, the highest ever. In 1999-2000, stock ownership levels were at 31-33%, at all time-high)
• Don’t fight the trend. If the primary trend is down, go short. If the primary trend is up, go long. Why fight the long-term direction of the market? Stop trying to be a hero.
• Watch financial networks and read newspapers and magazines to get an idea of where sentiment levels are. Magazine covers are my favorite.

Conclusion

“Follow the path of the unsafe, independent thinker. Expose your ideas to the dangers of controversy. Speak your mind and fear less the label of 'crackpot' than the stigma of conformity. And on issues that seem important to you, stand up and be counted at any cost.” – Thomas Watson

It’s safe to say that following the real professionals is the way to go. In order to do that, you have to know how they play. There are three points that I stress: 1) there is tremendous pressure and influence to join the crowd and gain easy acceptance, 2) the crowd is wrong in the majority of times, 3) under duress, psychologically, our emotions and objectivity can become distorted and cause us to rationalize (a dominant coping mechanism) or deny (a dominant defensive mechanism) even the basic realities of truth.

Investors will be able to join the crowd when appropriate, but remain flexible to leave the crowd at times when the market warns us. I encourage each investor to respect the nature of human weakness and to become a free-spirited independent thinker. Good luck!

Comments

[css1971:]

Or.

1: Set a percentage on any particular stock, fund, sector.
2: Stick to it.

Simple...

2008 Sep 02 09:04 AM

[Muzie:]

Your logic makes no sense.

The vast proportion of stock capital IS managed by so-called profesionals, aka "smart" oney. Retail investors are relatively rare, and individuals who manage their own portfolios and actively elaborate their own investments are a small part of the population. Again, the capital held by non-professionals is dwarfed by what is being managed by SWFs, hedge funds and mutual funds.

2008 Sep 02 11:29 AM

[Roowns:]

"Whenever you find yourself on the side of the majority, it's time to pause and reflect." – Mark Twain. I guess that's why he's dead now lol. He paused to think and the wave of destruction got him.

Now getting serious, we all know the theory. But I must admit it's an interesting study case..for a school boy.

2008 Sep 02 01:35 PM

[John C. Lee:]

Out of almost 2,100 diversified U.S. stock mutual funds that are open to new investors, just 17 have positive returns for both the past 12 months and year-to-date, according to investment researcher Morningstar Inc.

Muzie - you still call that "smart" money? Re-read my article.

2008 Sep 03 08:04 AM

[Beldar:]

Nice, accurate story. I am a very successful, professional, independent thinking trader. You have just explained how supply and demand work in the stock market. When everyone is bullish and fully invested, there is no additional demand available to push prices higher. Conversely, when everyone is bearish and on the sidelines, supply dries up and stocks rise - often very sharply in the face of a continuing slew of negative headlines! The irrefutable laws of supply and demand have been in force since Adam & Eve. Embrace it or perish.....

2008 Sep 03 09:16 AM

[leegee:]

Excellent article!!!!!!!!!!!!. I amj one of those non-professionals of which you speak; we ALL need to be reminded of The basics, over and over!
leegee

2008 Sep 03 02:52 PM

[Fabien Hug:]

Interesting read. However, these graphs are back trading. How do you know when despair or whatever has reached the market? Don't forget that Smart Money is only smart after the facts. Notwithstanding the basic rules of allocation of money towards risk and diversification, the remainder of the investing game is dumb luck.

2008 Sep 03 05:33 PM

[Fabien Hug:]

Interesting read. However, these graphs are back trading. How do you know when despair or whatever has reached the market? Don't forget that Smart Money is only smart after the facts. Notwithstanding the basic rules of allocation of money towards risk and diversification, the remainder of the investing game is dumb luck.

2008 Sep 03 05:33 PM

[John C. Lee:]

when you see those headlines in the media non-stop.

Smart money is not only after the facts. Identifying a top reversal (for example: large one-day reversals in industrials, materials signaled the start of a new downtrend) is definitely easier than trying to find a bottom, which is pointless. However, when a higher high and high low is achieved, then that's your signal to buy. That's what technical analysis is for.

2008 Sep 03 06:42 PM

[William Casby:]

It is fascinating to see how any discussion of market psychology, sentiment, behavioral finance etc invariably provokes sarcasm and hostility.

I propose this is because the "art' or inherent wisdom of contrarian thinking can't be neatly taught at MBA school, nor banged into a spreadsheet by an overpaid, one dimensional, right brain atrophied genius employed as a so called investment "professional".

These deeply frustrated, most likely highly correlated and YTD underwater types are the same "investors" who are also guaranteed to say:

'It was the PERFECT STORM";
"That was a FIVE standard deviation move!";
"These markets DON'T MAKE SENSE";

and my favorite one of all:

"Hey, we're NOT PAID TO BE IN CASH, OK?!?!"

Even more curious - when reminded that sentiment or market psychology may be at work, or persist in the face of their staggering fundamental genius, these so called investors will also say:

"Well.....NO SH*T.?!?!?!"

....OF COURSE we think about psychology?!.

..So does every "SCHOOL BOY' !!!!!!!!!! (as above)

Yet this is also usually said in an angry, defensive tone, when, once again, they have just dropped a ton of money in yet another "once in a lifetime" "perfect storm" event.

There is only one reason why it is so hard to invest successfully, and it is not because there is a worldwide shortage of MBAs, sufficient computing processing power or a lack of evolution in modern portfolio theory.


No, successful investing is very difficult because BUYING LOW and SELLING HIGH is perfectly CONTRARY to human nature.

Which is why the only way to outperform the market, is by being a "contrarian."

Mr Lee, thank you for a nice article.

Muzie, ROowns and others - maybe you should rethink your careers and go get a job preparing individual tax returns or something?


Cheers,


William Casby

2008 Sep 11 03:37 PM

[John C. Lee:]

William: I appreciate the comment. Thx!

2008 Sep 11 06:09 PM

[Roowns:]

Ehh. Now I saw your comment...

I'm just a financial journalist, so my carrier is fine, but thanks for the point.
I'm sorry if I was too harsh.

I am more of the opinion you need to take in consideration mostly "what NORMAL people think and act" to different events that occur in the markets to be successful and outperform it.
Sometimes, like what happened in octomber, you need to think about professional behavior too, but that's just once in a lifetime situation.
It might be a huge event for the economy, but if the markets doesn't react to it you can get crushed on short term.
Just because people are on the sell side doesn't mean you need to buy. If you'd get hurry you would have a huge red minus on the portfolio by now.
Saying you need to be "contrarian" to outperform is like saying you need to buy cheap and sell high. Doesn't make a sense to me, doesn't help me.

I myself got into this with a huge loss, because I was thinking buy and hold strategy, even I bought stocks after a 20-30% fall from high last year. That made me get interested what is the reason markets are so ugly.
I've read a lot of interesting analyzes in last few month, since in my country I was not familiar with American economy and global economy in general and now I made myself a theory on the big picture.
At the start of the year I was thinking 2008 will probably have a minus attached, but just in march I was sure and understood the crises at fundamental level and consequences for my country and rest of the world and why a tsunami in Beijing can start a meteorite rain in America and vice versa.

Hope that helps.

2008 Nov 05 08:04 PM

[John C. Lee:]

One contrarian view was the fact that so many people were blinded by the buy-and-hold strategy that they failed to realize that this is a traders market. I am up over 265% for the year after being up 62% in October and 62% (again) in November, so far. Think of other ways to be a contrarian instead of that usual conventional bs. And, don't "school boy" me. It all comes down to performance.

2008 Nov 28 12:38 AM