Ignore Sentiment - Here's Why To Buy

by: Jeffrey Dow Jones

I confess. I am a contrarian.

Maybe you've heard of us. We are the ones who ask, when things have gone very far in one direction and the general consensus is that they'll go even further, "perhaps it's time for a change?"

We are a minority (by definition), but not always a quiet one. I once wrote about why I tend to hold contrarian beliefs -- because I have found it to be both safer and more profitable -- and I had more people write in to me via email than I'd ever had before. So I know there are others out there. See if you agree.

Being a contrarian is simultaneously very easy and very difficult. On the one hand, it's pretty simple to pick out trends that have moved a long way in the same direction. Anybody can do this. But recognizing when those trends are about to shift is extremely difficult. It's impossible to pick those exact turning points, so contrarians have to be somewhat forgiving of themselves and each other.

Most of the contrarians I know tend to be more adept at thinking generally -- in big picture terms -- and less focused on the details of the day. It's hard to take a real position against the consensus, especially when the data all seem to suggest you're wrong to do so. Being able to get up above all of that and see the forest instead of the trees is something of a prerequisite.

Since April, investors have turned bearish. Very bearish.

The latest AAII Sentiment Survey reports only 23.6% of investors are bullish about the market for the next 6 months. 46% are bearish.

You probably don't need proof that investors are feeling kinda gloomy right now, but these were the big three headlines featured on the front page of Seeking Alpha last Friday morning:

I read all of those articles. They were good reads, excellent suggestions from the SA editors. They raise very important points. But the general theme of each was that things were going to stay difficult or get worse for a little while.

Basically: they confirm AAII sentiment.

As a contrarian, I disagree.

(Respectfully, of course! Nobody likes contrarians as it is, but what the world really hates are loud, angry, pushy contrarians. Perhaps more people would take us more seriously were we to maintain a nobler aura of dignity and gentlemanliness. I can at least try, right?)

What does it mean?

The first question you should ask is about context. What qualifies as an "extreme" reading of investor sentiment?

I've got AAII sentiment data going back to 1987. The bullish average is 39% and the standard deviation is 10.6%. So we're about a deviation and a half below the historical mean. That's significant enough to take note of and start asking questions. It's clearly outside the normal range.

Bullish sentiment has only registered a reading lower than 24% 91 times since 1987, a period of 1294 weeks. So this probably does qualify as a somewhat extreme reading. For additional context, during the first 3 months of 2009 when the market was going straight down and the investment world was as pessimistic as I've ever seen in my career, bullish sentiment averaged 27.5%.

Yes, you read that correctly: the market is less bullish now than it was during the first quarter of 2009.

The last time bullish sentiment got this low was the week of August 26th, 2010. Remember back then? That was when we were still really freaked out about a stalling U.S. recovery and also watching the wheels fall off over in Europe. That's probably when you first heard the term "PIIGS" or "unusually uncertain times." By that point you were probably inured to the image of Greeks throwing firebombs in the streets of Athens.

What happened next?

The market took off. That week of August 26th, 2010 was literally the low point of that correction.

After that the market proceeded to rally 300 points in 9 months. It was a 28% move in less than a year. Not too shabby.

Bullish sentiment hit 63% by the end of 2010, I should add. That was an extreme high, over two deviations above mean. Realistically, that probably would have been your out signal and you would have pocketed some nice gains after only 4 months. But the market kept on running for a few more months.

Sentiment tapered off through the spring of 2011, but by April it was at a much more normal 43%.

Let's Go Back Further

If you turn the dial on your time machine back a little earlier, the next most recent time that bullish sentiment was this low was the week of November 5th, 2009. The reading was 22.2%

What happened then?

The market rallied over 15% in the next 6 months. Assuming you acted on that contrarian signal and assuming you didn't get greedy and ride the trade too long, you made money. Probably good money, too.

Bullish sentiment was back up in the high 40s -- one deviation above historical mean -- by April of 2010. Hopefully you read that indicator in a contrarian fashion as well and didn't get swept up in the bullishness of that moment. It saved you some significant losses that summer.

And, of course, the time before that when bullish sentiment got this low was Q1 '09. We all know what happened after that.

With the exception of April 2005 (another great time to buy), you next have to go all the way back to February 2003 for a reading this low.

Uh, that was also a pretty awesome time to buy:

If you bought during the fear and pessimism of February 2003, my guess is that you made out pretty well.

Anyway, this is usually the way things go with extreme readings in investor sentiment. It doesn't always happen this way and sometimes sentiment can continue erode even further into extreme territory. But on balance, it's a pretty rock-solid contrarian indicator.

How to Play It

The easy way to play it is to just buy an index. The Diamonds (NYSEARCA:DIA) or Spiders (NYSEARCA:SPY) will do. Normally, I'm not an advocate of that sort of thing, but for a medium term trade like this, a general approach is probably better.

If you know how to trade options, this could be a great time to write some out-of-the-money cash-secured puts on the market. Demand for insurance has gone up dramatically in the last few weeks. It's hard to think of insurance as a good like any other because of all the emotion typically attached to it. But it's no different than any other good or service. When demand for insurance is heavy, that's when you want to be a seller of insurance. When nobody wants insurance, that's when you should think about being a buyer.

If you've got a portfolio of individual stocks, or have a shopping list of stocks you have been thinking about adding to, now's the time to do it.

Since this is Seeking Alpha, I am obligated to mention Apple (NASDAQ:AAPL) at least once in every article (I kid!). But honestly, this a good example of a company with idiosyncratic issues right now selling off sharply for its own reasons. That's NOT what you're looking for with a general signal like this. So don't use this sentiment reading as a reason to justify an Apple purchase.

Depending on how you feel about energy prices, you could get a double whammy with some major energy stocks. Should market sentiment improve and the market rally, that'll be good for the usual names like Exxon (NYSE:XOM) and Chevron (NYSE:CVX) and Shell (NYSE:RDS.A). Or just buy the darn XLE. If you think that oil prices are bottoming out here or could rally, that might offer a bit of a cushion on this trade if the rest of the market drops further.

There's a final roundabout way to play this trade, and that's to get short bonds. I really like this idea. The yield on the 10 year treasury is at record lows. RECORD LOWS, people. That's an interesting medium-term indicator on its own. In any case, should the market rally, yields will climb and bonds will fall. And with yields so compressed right now, that could give you a little more of a cushion than you might have with the stock market in case you're wrong.

I've never been a fan of the leveraged ETFs and the inverse ETFs. I'd rather just short the IEF, TLH, or TLT, myself. But if you want to get a 1x short bond ETF like SAGG, TYNS, or TYBS, I suppose that's probably fine too. Make sure you read all the disclosure on those funky ETFs, though. I'm kinda old school and some of the stuff in those prospectuses makes me a little nervous.

Some Caveats

I should also add that this signal is indicative of beginning to establish a position. Our firm manages a group of hedge funds, and one of the things we do with longer-term, contrarian trades like this is to scale into them. It's impossible to pick tops and bottoms, so we prefer to build positions gradually rather than go all in or all out.

If bullish sentiment continues to erode, think about adding to your position. If sentiment sharply corrects, it will almost certainly mean you made money as the market rebounded. Be happy with those gains. If the market and sentiment each churn around for a while, be patient. The AAII Sentiment Survey is supposed to get a read on where investors think the market will be 6 months out.

The AAII even published a pretty good paper about how to use the survey as a contrarian indicator. Check it out.

Please, don't go into this trade willy nilly. Don't do it. Set clear parameters before you put on the trade. Have your exit strategy ready before you initiate the position. I can't tell you how many rookie traders make the mistake of getting into a position with no clue how to get out. It even happens to the pros from time to time.

The Final Caveat

As always, don't ever use a single indicator to make an investment. The best trades incorporate a confluence of signals and indicators. Technical analysis is a great resource to have in your back pocket for a trade like this. Knowing the Ten Commandments is a good place to start and could help make this current trade an even better one.

If you're a fundamentals guy -- and we know there are plenty of those here at Seeking Alpha -- turn to your fundamental toolkit as well. Fundamentals usually support the consensus, but not always. Solid fundamental data that refutes the consensus is among the most valuable things in the world.

One of the best macro traders I ever came across told me that once at an investor event he was hosting. He told me the way you really make a killing in the market is to be both contrarian and fundamentally correct.

That was Peter Thiel, by the way. He made a billion or so dollars last Friday when Facebook (NASDAQ:FB) went public. He made that investment, of course, when nobody believed in Facebook. When MySpace was eating their lunch and consensus was convinced they'd become another also-ran.

It's hard to go against the herd, but if you have the stones and some data to back your thesis up, it's possible to make a buck or two every once in a while.

Disclosure: I am long XOM.

Additional disclosure: For a full disclaimer see cognitiveconcord.com/legal-notice