Contrarian Indicator Signals It's Time to Buy... Here's What

November 9, 2013

GDP in the third quarter rose 2.8% instead of the 2% economists expected. This was framed as bad news in many news stories because the jump resulted from larger-than-expected inventories.

Just over a week earlier, the U.S. Census Bureau released a report on the inventory-to-sales ratio showing inventories weren't really a problem.

When a business sees sales rising, it will often increase its inventory to meet the higher demand. The relationship between inventory and sales can be summarized in a ratio that shows how many days' worth of inventory is available based on the amount of sales recorded in a day.

The inventory-to-sales ratio was 1.29 in the most recent report, which used data from August, down from 1.3 a year ago. Inventories rose 3.1% compared to a year ago, while sales increased by 4.2% over that time. We would expect to see inventories increase if sales are rising, and the decline in the ratio shows that sales are rising faster than inventories.

News reports seem to reflect the mood of the market, and that is the basis for the "magazine cover indicator." According to this indicator, when the media develops a consensus, the market moves the other way. In other words, popular media can be a contrary indicator of the markets.

The magazine cover indicator has been the subject of academic research that supports its efficacy. One study, a 2007 paper by three University of Richmond professors called, "Are Cover Stories Effective Contrarian Indicators?," looked at feature stories in Business Week, Fortune and Forbes over a 20-year period to determine whether positive stories are associated with superior future performance and negative stories are associated with inferior future performance for the featured company.

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The authors concluded that there is "a statistically significant correlation between the appearance on the cover of one of the magazines and the subsequent performance of the company's stock."

Over the years, it has been applied not only to stocks, but to the market as a whole.

In addition to bullish cover stories, there is constant media coverage of the markets, and in our opinion, that coverage has taken on a bearish tone. The GDP report is one example. The Twitter (TWTR) IPO is another.

Many articles compared Twitter's first day of trading to the 1999 Internet bubble. Twitter may be overvalued, but one example is not enough to demonstrate a bubble. The 1999 stock market was unique, and the media coverage of the time was uniformly bullish, as day traders became media stars. The magazine cover indicator worked in 1999 as that market turned lower while the news was bullish.

The way we currently interpret media coverage of the economy and market is bullish for stocks. This negative tone reinforces our opinion that stocks should continue moving higher into the end of the year.

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With a bullish outlook, the question is what to buy. The top ETFs in our system are:

-- Industrial Select Sector SPDR (XLI)
-- iShares Russell Top 200 Growth (IWY)
-- iShares Russell 1000 Growth (IWF)
-- iShares Russell Top 200 (IWL)
-- Health Care Select Sector SPDR (XLV)

Within each of those ETFs, we looked through their largest holdings for a call option that should be able to deliver at least a 10% gain before the end of January.

-- General Electric (GE) January $27 calls at $0.85 or less
-- Oracle (ORCL) January $34 calls at $1.50 or less
-- Altria Group (MO) January $38 calls at $0.50 or less
-- Microsoft (MSFT) January $38 calls at $1.25 or less
-- Pfizer (PFE) January $31 calls at $0.95 or less

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From that list, MSFT is our favorite trade. The stock is likely to get a lift from news when the company announces its new CEO. Manage the risk on this, and other call options trades, by buying in small amounts rather than using stop-loss orders.

We believe the stock market is bullish and traders should ignore the bearish news stories. They should buy the strongest stocks or call options on those stocks to benefit from the bull market while it lasts. When the market turns down, there will be time to be bearish, but the media should never dictate your market outlook.

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