Practically everyone who reads financial news has heard the old Wall Street proverb “the trend is your friend,” but few have been inquisitive enough to ask “what if the crowd is wrong?” The efficient market theory fails to take into account emotions, which for better and for worse, are a key driver of investing decisions. Because of this phenomenon, the market has a way of rudely surprising so-called experts when it moves against the sentiment of the majority, often causing more panic selling along the way [see 101 ETF Lessons Every Financial Advisor Should Learn].
The great Sir John Templeton further showcases the link between emotions and stock prices in his famous words that “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.” So what’s the average self-directed investor to do?
Contrarian indicators stand to offer valuable insights in times when every other research tool and market expert out there are flashing the same signs, whether its forecasting “great gains ahead” or that the “worst is yet to come.” By definition, contrarian investors are known for going against the prevailing market trend in times of sentiment extremes; this means buying when others are panic selling near the bottom, as well as taking profits when retail investors flood the market right before the top [see Picture Edition: 3 Market Valuation Indicators ETF Investors Must Know].
As you may have suspected, pinpointing the right time to bet against the crowd is no easy feat, but there are tools out there to help sort through the sea of data and opinions. Below we highlight three popular contrarian indicators that have historically offered clues as to when the market tide may turn, although it is important to keep in mind that investors should not rely solely on any individual indicator; instead, it is most prudent to utilize a number of tools when formulating your investment strategy.
1. Mutual Fund Flows
Retail investors are notorious for being the worst market timers; they usually arrive right before the party crashes and they also have a tendency to “cut losses” right before the market bottoms out. Contrarian investors have long relied on mutual fund flows data to spot which way the “dumb money” is going; the premise here is that when mutual fund outflows are at their worst, smart money starts to buy in again in anticipation that the extreme pessimism will soon reverse [see The Complete Visual History Of SPY].
For a visual interpretation of this phenomenon, consider the chart below which is based on monthly mutual fund flows data provided by the Investment Company Institute:
The biggest takeaway here is being able to spot that the largest outflows came at the end of 2008, just a few short months before the U.S. equity market bottomed out in the beginning of March the following year.
2. Volatility Index (VIX)
The CBOE Volatility Index, more commonly referred to as the “fear index” or simply VIX, is a figure derived from the weighted blend of prices on a range of options on the S&P 500 Index. The result is a benchmark that rises when volatility in the options market increases, which is typically accompanied by a decline in the stock market. Contrarians are known to use this indicator to gauge sentiment extremes because “fear” levels tend to peak right before the actual bottom, and there is generally “little to no fear” as the market nears its top [see Visual Guide To Major Index Returns From 1970].
The chart below is based on monthly VIX readings from Yahoo! Finance:
Notice how the VIX soared to all-time highs before the market proceeded to bottom out in early 2003 and later again in early 2009; the takeaway here is that investors have been most “fearful” when the worst is almost over.
3. AAII Sentiment Survey
What better way to gauge the sentiment of the “herd” than to poll them? Contrarian investors love to reference the AAII Sentiment Survey. Published every week, the American Association of Individual Investors survey looks to measure the percentage of self-directed market participants who are bearish, bullish, or neutral about the stock market over the coming six months. Similar to the insights offered by tracking mutual fund flows, the sentiment survey is used by contrarians to get a feel for when the “dumb” money is nearing a sentiment extreme, whether it’s untamed euphoria or unreasonable fear [see How To Hedge With ETFs].
When bullish sentiment rises well above its long-term average (listed on the AAII website) investors should be wary of a pullback; likewise, when bearish sentiment is well above its long-term average it may be prudent to start looking for buying opportunities as the dust settles.
The Bottom Line
Contrarian indicators can offer valuable insights when it comes to pinpointing market sentiment extremes, which is often the most opportune period to take positions given the clouds of uncertainty faced by the majority of investors. Nonetheless, contrarian indicators are not without their faults; false sell signals and early buy signals are a common nuance when utilizing these tools, which is why investors would be best off to use these indicators in conjunction with other tools and analysis before deciding to pull the buy/sell trigger. As always, investors of all experience levels are advised to use stop-loss orders and practice disciplined profit-taking techniques.
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Disclosure: No positions at time of writing.
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