Contrarian Investment Strategies
Over the last several decades a number of different investment strategies have evolved. All of them were designed to help investors be able to successfully time the up and down moves, that occur on the world equity markets. However, the overall results have varied dramatically as investors, traders and analysts argue about which theory is the best one to achieve this objective. At the heart of this argument, is the belief that the markets will overshoot in both directions. Where, some will claim that the markets reflect all expectations and available information in the price of the stock (commonly called the Random Walk Theory). This makes it impossible to determine if the markets will move up or down-based past market conditions. While, contrarian investors will argue that the markets are known for large amounts of volatility. This is because the markets are run by the emotions of fear and greed. During times when the economy is expanding and the averages have outperformed their historical rate of return, is when the emotions of greed will affect investor psychology. At which point, the markets will form bubbles that are created by this chasing mentality, that is affecting both the individual and professional investor. It is at this point that the market is overvalued because of these emotions from the crowd, where a major reversal is more than likely to occur at some point in time. During those times when the economy is performing poorly, is when the markets will become undervalued. This is because the emotions of fear are causing the majority of investors to become risk adverse. As a result, they sell their most liquid and volatile assets (stocks / options) first. Once this take place, it means that a wave of selling will drive stock prices lower. According to contrarians, these two extreme moves that are occurring in the markets allow all investor to be able to take advantage of the price irregularities that are occurring. Where, the prudent contrarian investor will short or sell stocks when the crowd is optimistic. Then, once the crowd is no longer interested in stocks, is when they are able to buy many companies at a fraction of their value. This gives them a much better return, because they were able to take advantage of these irregularities.
To determine if the contrarian investment strategy is effective requires examining how this strategy has been able to predict major market reversals. This will be accomplished by: examining the different approaches used by this investment strategy, how the use of different contrarian indicators can predict major market reversals, which contrarian tools / indicators are the most useful and analyzing the different trading strategies. Together, these elements will provide the greatest insights as to how effective the contrarian investment strategy is in determining the movements of the major stock market averages.
The Different Approaches used by the Contrarian Strategy
What is a contrarian strategy?
A contrarian investment strategy is when you are monitoring the general mood of investors to determine if market prices are over or undervalued. This is because investors / traders are affected by one of several different situations that will help contribute to the overall emotions being felt with investing to include: placing more of an emphasis on current information, panics and not being able to fully understand the financial terminology or how the various financial-based products work. Investors generally will place more importance on information that was received most recently, rather than examining the trends of the underlying stock. This means that when a company reports much better or worse earnings, there will be a sharp volatile move reflecting these emotions. Panics have the ability to feed upon themselves, where a certain amount of selling or buying will take place based on perceptions about what is going to occur. During times, when the news is negative this can cause a panic, with investors wanting to sell their stock at any price. Then, there are the programmed sells such as sell stops. This is an order to sell a stock that is determined in advance. During panics, these stops trigger even more selling, as stock prices break through key levels of support. The overall complexity of various financial products such as: swaps and derivatives trading causes even more emotionalism with investors. This is because these kinds of investment products are complicated and unknown to the average investor. When someone purchases something that they do not understand and it begins to decline, there is the possibility that investors will become worried about severe losses. Once this begins to take place, is when investors will become emotional.
At which point, the overall amounts of volatility will increase. What this shows is that the different factors can work together or separately to cause the investor to question their motivations for buying or selling a particular asset. This is when they will begin to question the decision and engage in actions to rectify the situation. When millions of investors are doing this, it means that the stock market averages will have volatile movements. At which point, the chances increase, that markets will become too expensive or to undervalued because of these emotions.
What does contrarian investing capture?
Contrarian investing captures the emotional sentiment of the investing crowd. This is important because this information is used to help make investment decisions going forward. However, in some cases these issues of sentiment that have been identified; will point to the strength or weakness of the underlying trends in the market. Where, contrarian indicators will show that the markets are overbought or oversold, yet there is enough demand for stocks from investors that the trend will continue.
What this captures, is the overall feelings from investors and traders, prior to a major reversal in the markets. This could take place over the short-term or the underlying trend could continue until the forces of supply and demand become more imbalanced.
What is the interpretation?
The interpretation of the contrarian thinking is to be able to identify changes that are taking place early in the trend. Where, contrarian thinking will help provide a general overview as to if the price of the stock / markets are over or undervalued. However, the majority of investors do not understand that when a contrarian buy or sell signal appears and that it must be correlated with other information. This is because once a buy or sell signal emerges, it could take several days or years to see the actual change in trend. An example of this occurred during the bear market of 1973 to 1974, with the Dow Jones Industrial Average, where the markets were indicating in mid-1974 that equity prices were becoming severely oversold. However, the bottom in the market averages would not occur until late 1974, as this would spark a rally in asset prices that would last until 1977.
The Use of Different Contrarian Indicators to Predict Major Market Reversals
The continuing debate that is often very heated among Wall Street analysts, traders, investors and economists is: the overall effectiveness of contrarian thinking. This is because many investors will argue that purchasing stocks that mirror the major market movements will provide more diversification and protect for your portfolio from the volatility, which often accompanies volatile stocks. As a result, they believe that the long-term market averages will provide more consistent returns than effectively trying to time the markets. An example of this can be seen with a contrarian investment strategy called vulture investing, where investors are purchasing the common stock and the debt of those companies that are on the verge of bankruptcy. The idea is that investing in these kinds of companies, there could be possible situations such as: an acquisition or merger; that would change the fortunes of the company. Once this occurs is when these investors will see a dramatic appreciation in their investments.
While this is true to a certain extent, these skeptics are ignoring the fact that contrarian thinking is not speculation. Instead, contrarian investing is when you are using the market conditions and the emotions tied to a particular stock / the markets, to determine if it is overbought or oversold. An example of this can be seen with comments from Ben Graham (who was an advocate of the valuation / contrarian approach to investing) where he said, "What do we mean by investor? We attempted a precise formulation of the difference between the two, as follows. An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. We have clung too tenaciously to this definition over the ensuing 38 years. After the great market declines of 1929 -- 1932 all common stocks were widely regarded as speculative by nature. (a leading authority at the time stated flatly that only bonds could be bought for investment). Thus, we had then to defend our definition against such charges that gave too wide a scope to the concept of investment."
This is significant because it shows how some critics of contrarian investing will often point to the various instances of speculation and assume that it is contrarian investing. In some cases the psychology of consumers can become so extreme, that the definition of what is speculative expands greatly. As a result, using contrarian investing in conjunction with other indicators / tools can help prudent investors and traders, be able to identify when the market condition are becoming more extreme.
Contrarian Indicators and Tools
When using the different contrarian indicators / tools in conjunction with one another, you can begin to see how this strategy can be used, to effectively determine if the market conditions are overbought or oversold. There are number of different tools that can be utilized to indentify major changes that are occurring in the trend of a stock or the market averages. These would include: headlines within the mainstream press, the different put / call ratios, ISEE sentiment indicators, the VIX, the VXN, investor intelligence surveys, short interest and correlation with what is being seen with the industry or the major market averages around world.
Headlines
When looking at the first tool that can be used, the headlines within the mainstream press, it is clear that this can provide a reading as to the overall mood of the investing public. Where, the press will report on those issues / situations that are important to the public, as they will talk about the various views on what is taking place. To illustrate the greatest amount of emotions, a snappy headline will appear to convey this feeling. If this happens consistently enough, many contrarians will use this as one of the tools to confirm if the investing public is to pessimistic or optimistic. An example of this can be seen during the summer of 1982, when many analysts and economists were predicting that the Dow Jones Industrial Average was going to 500, while the economy was heading into a major economic depression. Where, many headlines from across the country would say, "IMF seeks to calm jittery bankers. Mortgage delinquencies hit the highest level since 1965. De Deers reports worst the period since the 1930s."
What this shows, is that all of these different headlines that were seen during the summer of 1982 would indicate a major reversal that was getting ready to occur. Where, the markets would identify a major change that was taking place in the trends of the major market averages around the world. An example of when the markets have become overvalued; can be seen during the summer of 1987 with the common headlines saying, "Chrysler reports best quarter ever. Stampede for stocks becomes a scramble. The bulls are coming."
What this shows is that the headlines during the summer of 1987; would highlight the overall atmosphere of greed that was encompassing the markets. As a result, it would only be a matter of time until a major reversal would take place. Where, both examples illustrate how using the headlines from the popular press can be one way of indentifying the overall mood of investors and the general public. This is one of the first steps to knowing if the markets are overbought or oversold.
The Put Call Ratios
The put call ratio is when you are looking at the total amount of open puts to open calls that are trading on the Chicago Board of Options Exchange (CBOE). To fully understand how the put call ratio works requires examining the purpose of options. Simply put, an option is a contract that is giving the owner of a specific stock or security the right to buy or short, a particular investment at a particular price. A put is when an investor will purchase an option that requires the value of the underlying investment to decline. The way it works is the investor who purchases a put, has the option of shorting the stock at a particular price. If the price of the stock declines beyond the price that owner agreed to when purchasing the option (the strike price), then the option has seen an increase in value. While, a call is when an investor will purchase an option that requires the value of the investment to increase. Like with a put option, if the value goes beyond the strike price, then the call will see a significant appreciation in value.
However, if the option does not move beyond the strike price by the time it expires, then it is worthless. The risk that the investor faces is: the amount that is paid for the right to buy or short a particular investment called the premium. Depending upon the time frame to expiration and the value of the stock in relation to the strike price, this will determine if the value of the premium is increasing or decreasing. The put call ratio can be used as a way to gauge the overall emotional sentiment of the crowd, where high amounts of open put or call buying can be used to show how optimistic or pessimistic investors are looking forward. There have been a number of different studies that were conducted on this subject, with the most notable being: one that was conducted by MIT called, the Information in Option Volume for Future Stock Prices. Where, the author found that following the put call ratios of the various stocks are: an accurate indicator of the emotionalism that is being seen from the crowd. They then wanted see what the results were of those stocks that had low put call ratios in relation to the performance of the stock. What they found, was those stocks that had low historical amounts of open put or call interest from the general public outperformed the major market averages by 1% within one week.
This is significant because it underscores how looking at total amounts of put or call buying, can help investors to have another tool to measure the emotionalism of the crowd. For example, a study of the effectiveness of the put call ratio took place in Japan following the Nikki 225, using the put call ratio as the sole indicator to make investment decisions. The authors of the study found that when the put call ratios falls to extreme levels, they were an excellent indicator in predicting the reversal that would take place in the Nikki.
This is important because using this information along with the previous study that was conducted on the put call ratio, highlights how this tool can be used to determine if the markets are becoming overbought or oversold. The reason why this has been shown to be effective is: it helps to identify extreme changes in the forces of supply and demand. Where, if the prudent investor is using this tool to identify extreme price irregularities, then the odds are high that some kind of reversal is imminent.
Put Call Ratio Tools
Thee are a number of different tools that traders and investors will use to determine if the markets are overbought or oversold to include: the CBOE equity put call ratio, the CBOE index put call ratio and the CBOE total put call ratio. The CBOE equity put call ratio is when you are looking at the total amounts of puts and calls that are traded on a particular stock, over a period of time. It will trade as one single indicator that will show the lows and highs of the total amounts of put call buying that are occurring.
When the put call ratio has reached extreme points, it is a good sign that the markets are about to make a major reversal. For example, in February 2008, the CBOE put call ratio would reach a one year high. This would signal that many investors were optimistic about the future of the economy.
At which point, it would only be a matter of time until a major reversal in the trend would take place. This is significant because it underscores how the use of this tool along with other contrarian indicators will help to provide, better insights as to if the stock / markets are overbought or oversold. In general, when the equity put call ratio rises to 1.0 this is a bullish sign, which means that investors and traders in the stock have become to fearful. At which point, many contrarian traders and investors will begin purchasing the stock long or they will buy the call options. When you see a reading of .5 or lower, this is a sign that the price of the stock could be overbought (bearish). Once this kind of situation is observed, it is advisable that investors / traders tighten their sell stops or begin purchasing put options.
The CBOE Index Put Call Ratio
An index put call ratio is when you are measuring the total amount of open puts and open calls that are trading on the various indexes. What happens is this indicator, is used by traders and investors to determine how optimistic or pessimistic the crowd is for the underlying averages. If the index put call ratio is at historical highs or lows, then this could be an indicator that prices have become overbought / oversold, signaling a major reversal in trend. This indicator can be used in conjunction with the CBOE equity put call ratio to determine if a particular stock and the averages that it trades on are over or undervalued.
Using the example that was mentioned earlier, when a trader sees that the CBOE equity put call ratio and the CBOE index put call ratio are at extreme points, this is a sign that a the trend in both the stock and index are becoming over / under valued. However, traders can also use this information to confirm what is occurring within the individual stock. Where they could see an extreme reading from the CBOE equity put call ratio on stock, but a confirmation that the trend on the average is still in place. In this particular situation, some traders and investors would use this as a way to be able to identify short to medium term trading opportunities within a particular stock. When you see a reading on this indicator of: 2.0 or higher this is a bullish sign, that is saying that investors and traders have become to pessimistic. A reading of .90 or bellow is bearish sign; that is saying prudent traders and investors have become more cautious, about the upside of the markets as well as stocks going forward.
The CBOE Total Put Call Ratio
The total put call ratio is when you are looking at the total amount of calls and puts that are trading on the CBOE. This would include all the different options that are trading on: stocks, indexes and long-term equity options. This can be used in conjunction with the above mentioned indicators to determine the overall mood of investors. In general, when this indicator rises above 1.0 it is good sign that investors are to fearful, which would be a bullish for purchasing calls or equity securities long. When this reading falls to .5 or bellow, it is a good indication that investors are to optimistic about the future, which would mean that it would be advisable to begin to take profits or to start shorting and buying puts. The total put call ratio has been shown to be effective at identifying when major changes in the long-term trend of the markets are taking place. A good example of this would be when Martin Zweig used this indicator to sell stocks in the summer of 1987 and began shorting / buying put options. As a result, he was able to profit from the stock market crash that would take place in October of 1987. This is significant because it shows; how using this indicator can serve as an early warning sign that the price of equities is becoming overbought or oversold.
The Popularity of the Put Call Ratio
After the 1987 stock market crash, the put call ratio became a popular indicator within the mainstream press. Part of the reason for this was because of the notoriety that Zweig had seen from using this indicator, to determine a change in the trend of the markets and the increased amounts of options information available to investors.
As a result, many investors began to use this indicator to determine if the markets and stock prices were over / undervalued. In contrarian thinking once this begins to take place, it means that the effectiveness of the readings can lead false signals. This is because once a tool / indicator have become popular, they will be talked about more in the main stream press and an increasing number of investors will use this tool to make buy / sell decisions. At which point, it is only a matter of time until the buy / sell signals are not as effective as they once were. A good example of this can be seen in June 2005, when the CBOE index put call ratio had shown a reading as high as 2.75. While, the equity put call ratio and the total put call ratios would show reading above 1.0.
For most investors, this would seem like the ideal time to purchase stocks, as all three indicators would show that the markets were severely oversold. However, because of the popularity of these indicators over the last several decades, they have begun to show false signals. What happened was, on June 23rd CNOOC (one of China's leading oil companies) announced that they would be purchasing Uncial. This created a heated debate in Washington, as to if Chinese companies should be purchasing large American companies that are vital to the defense of the United States. As a result, the Dow Jones Industrial Average would fall 290 points. The drop would prove to be short lived, as the Dow would be able to recover from this point, once the proposed acquisition was abandoned by CNOOC. What this shows is that because the different put call ratios have become popular, you can receive signals showing the markets are overbought or oversold early. As a result, this could mean that there will times that situations like the above scenario, will cause the markets to move the opposite direction of what the put call ratio is indicating. To effectively use these different tools, requires taking the taking a long-term focus and understand that the price of the stock could move in the opposite direction because of it is spotting early changes in sentiment.
ISEE sentiment indicators
The International Securities Sentiment Index (ISEE) is: one of the newest of the sentiment indicators. This tools tracks the total amount of put call buying that is taking place on the International Stock Exchange (ISE). As the world of options trading has expanded, the ISE has quickly filled the obvious void and has become one of the largest markets for trading options and futures. Since it is considered to be a rival to the CBOE, the sentiment indicator can be used to confirm the overall bullishness or bearishness that is taking place. The way it works is similar to the CBOE put call ratio tools that traders and investors are using. Where, the total amount of open put and call contracts are closely scrutinized to determine the sentiment of the crowd.
However, there are a number of areas that make ISEE different from the sentiment tools used on the CBOE the most notable would include: the way that the formula is calculated for determining this ratio and the way it measures the total amount of put call purchases that are taking place. The ISEE is calculated using a different formula in comparison with other sentiment indicators. The way that it is calculated is completely different from the CBOE put call ratios. What happens is this number is calculated by taking the total amounts of call and put buying, and then dividing the two numbers into each other. At which point, the number is multiplied by 100, to see the total amounts of fear or greed that investors have on the about the future.
A second difference between the ISSE and the different CBOE put call ratios is: the way that the different contrarian indicators measure the total amount of put call ratios. On the CBOE all of the different put call ratios, use large amounts of volume to determine the overall activity that is taking place in a particular stock or index. When there are large spikes in volume and the total number of puts or calls that are being purchased increased. This is used to show how positive or negative investors / traders are, about the future prospects for a particular investment.
Some critics of contrarian thinking have argued that under the way the put call ratio is calculated on the CBOE, it will cause the number of false signals to increase. This is because the use of volume will tell you the total amount of put and call buying that is taking place. The problem is it does not account for call and put writing. In options, when someone is writing a call or put, they are initiating the selling of an option contract. Where, they agree to sell the stock to the buyer of their call or put option, 100 shares of stock per contract, at an agreed upon price in the future (the strike price). The main reason behind writing options is to use this as way to generate income off of the premiums received. What happens is an investor could believe that the price of the stock may remain in the current trend for a while. To protect themselves or to make additional income, they will write a call / put option on: a stock, index or other investment. If the price of the stock does not reach the strike price, then the writer of the option will keep the premium. However, if the price of the stock exceeds the strike price, then the party that wrote the call / put is obligated to deliver the full shares of the stock to the party that purchased the option contract (100 shares per contract).
This can be problematic, because large amounts of call and put writing can cause the CBOE put call ratio to increase or decrease more than it should. The ISEE looks at the total amounts of put and call buying that is taking place during the day, where any kind of put or call options that have been written are ignored. As a result, this number is designed to provide a precise reading of investor sentiment.
Bullish and Bearish Readings on the ISEE
The ISEE has a scale that is used to determine how bullish or bearish investors are. Where, the indicator will trade between a range of 125 and 225. When the number rises to 200 or above; this is a sign that the investors / traders are becoming too optimistic about the future. While, a reading of 140 or below would indicate that the markets are becoming oversold. For example, in 2004 this indicator would rise above 200 19 different times. Then, the indicator would reverse and test the 140 mark.
In December 2004, when the ISEE reached a low level of 105, it would signal that investors / traders were to pessimistic about the future. At which point, it would only be a matter of time until the major averages would have a significant that rally takes place. This is significant because it shows how investors have a second tool that can be used to determine the overall attitude of investors and traders going forward. Due to the fact that the ISEE is so new, many investors are not using this contrarian tool as much. As a result, this indicator can be used in conjunction with the different CBOE put call ratios to determine the overall amount of sentiment in the markets.
The Volatility Index
Volatility is another tool that used to gauge the overall amounts of fear or optimism that are in the markets. Like with many other contrarian indicators, this moves in an inverse fashion in relation to the markets. Where, as the amount of volatility is rising or falling, the markets will move in the opposite direction. Simply put, volatility is one measure that used to determine how much the price of the stock has moved or how far it can potentially move in the future. The reason why this tool is used; is because when volatility begins to occur, it usually takes place when there are changes in the trend or there is a correction.
As a result, once investors become more fearful about the future is when you will see an increase in the overall amounts volatility.
The biggest reason why is: most investors / traders will look at the volatility, to help provide an accurate determination as to what is occurring with crowd. During times when investors are fearful, they will purchase large amounts of puts to have some kind of downside protection (indicating that the crowd is more bearish). While, low amounts of volatility would indicate that that crowd is optimistic about the future, at which point they begin purchasing calls. The rational is that during times of uncertainty or bear markets the overall amounts of volatility will be higher, than those periods where the economy and the markets are performing well.
There have been studies conducted to determine the overall accuracy of volatility in helping to predict the future moves of the stock market. One good example of this can be seen with the journal article titled, VIX Index and Interday and Intraday Volatility Models. Where, the authors are trying to determine if volatility is an accurate way of predicting the future moves of the stock market. To achieve these objectives, researchers would evaluate the total amounts of volatility that would take place on the CBOE from 1990 to 2003. As a result, the authors found that those days that have high amount of volatility indicate how the markets will be trading over the next two to three days.
This is important because it shows how using this indicator in conjunction with the other contrarian tools can allow traders to see the total amounts of fear or lack of fear that investors / traders have.
Volatility Index Tools
The three main tools that are used to determine the overall amounts of volatility include: the VIX, the VXN and the VXO. The CBOE Volatility Index measures the total expectations for the overall amounts of volatility in the markets over the next 30 days. This is accomplished by looking at the volatility that is occurring in calls and puts that track the S&P 500. For all of the different volatility indexes investors will use a scale that ranges between 0 and 100. When the scale is sitting at the low end of range: the area between 10 and 20 or below; is sign that investors are optimistic about the markets. As a result, prudent traders and investors would become nervous when it hits such low levels. This is because of the optimism that is being seen from the crowd. When the VIX rise to levels that are between 20 and 50 or higher, this is a sign that investors are fearful about the future, indicating that traders / investors should be taking long positions.
A good example of the overall accuracy of the VIX can be seen with how it performed throughout the late 1980's into the mid-2000's. Where, the index would hit an all time high of 170, after the 1987 stock market crash. Then, during the 1990's the different ranges would be used to correlate the positive or negative emotions that crowd has about current conditions. With the index using the different trading ranges mentioned above to highlight the overall amounts of fear or lack there of. Evidence of this can be seen during the Asian Financial Crisis of 1997, when the index would rise to 60. This follows a period of several years, when the VIX would have consistent readings between 10 and 20.
What this shows, is that when the VIX rises to extreme levels, prudent traders can be able to use this as a way to determine how optimistic or pessimistic the crowd is about the future for equity prices. At which point, they can use this fear to be able to make investment decisions that will allow them to take advantage of changes in the trend.
VXN and VXO
Like with the VIX, the VXN and VXO measure the total amounts of fear or greed that investors are feeling about the future of investment prospects moving forward. The difference between these tools is the actual indexes that are measuring volatility. Where, the VXN will measure the volatility of NASDAQ Composite, while the VXO is used to measure the total amount of volatility on the S&P 100 index. Prior to 1993, the VXO was considered to be the only volatility index, which first began measuring the total amounts of volatility in 1986. What this shows, is that traders and investors have a number of different tools to see how fearful or optimistic investors are about the future.
Where, each one can be used to confirm, if the mood of the general public is to optimistic or pessimistic. For example, traders will often use all three volatility to tools to determine the overall amounts of sentiment. Where, they will look for a correlation between all three different indicators to gauge the overall sense of emotionalism that many investors are feeling. This means that they would look for the readings on all three indexes to generally be within the same trading ranges. Meaning, that they would want to see similar readings from all three averages; where you are looking for a consistency in readings from the different indicators in the 10 to 20 range and a consistent reading in the 20 to 50 range. Once this takes place, it means that there is correlation that the three major market averages are experiencing extreme amounts of sentiment.
The Drawbacks of Using Volatility
The biggest drawbacks of using the VIX, VXN along with the VXO are: that the mainstream press will often talk about all indicators when volatility increases or decreases and they have been known to provide early signals.
Over the last ten years, the financial press and many traders will often use the different volatility indicators to determine if stocks or the markets are overbought / oversold. When this begins to happen, it means that many investors will often miss read the different signals for the indexes. Where, the levels of volatility will rise or fall; as many investors will often overlook the actual interpretation from these numbers. At which point, they will assume that the markets will once again resume the previous course that they were on. A good example of this can be seen by looking at the VIX from 1998 to 2002. What happened was; the overall amounts of volatility would rise sharply during the Asian Financial Crisis of 1998. Then, once investors became less concerned about the markets, the index would fall in between the high teens to low 20's. This is higher than the levels seen during the early to mid-1990's. In this example many, investors would see that the high amounts of volatility in 1998 as an excellent buying opportunity. However, the in ability of the index to reach the same low levels in the mid-1990's indicates, that a new trend was emerging. Where, a number of different situations could cause the overall amounts of fear to rise sharply. Those investors, who failed to read this change in trend, would participate in the bubble that took place between 1998 and 2000. What this example shows, is that the different volatility tools are used to provide an overview as to when investors are becoming to fearful or optimistic.
Yet, many investors misread the extreme changes in sentiment, where they will become nervous, then ignore the index when it shows extreme amounts of optimism. This is problematic, because the extreme amounts of fear or greed will push the markets in one particular direction. The only way to change views would be to see a dramatic reversal in the overall amounts of volatility.
A second drawback of using volatility is: that it is known to provide early signals to investors about possible changes in the trends of the markets. Using the previous example, in 1998 the sharp rise in the VIX would indicate a long-term change in the trends and sentiment of the markets. Where, it would foretell of a secular bear market that was emerging because of the large amounts of fear. The problem is: that this reading would underscore a change in the trend to early. At which point, many investors will assume that the extreme amounts of fear signal a long-term buying opportunity. This causes them, to begin engaging in actions that will hurt the performance of their portfolio. The reason why is because of the early signal that is provided, where the VIX remained low during much of 1990's. This is because the favorable economic backdrop that supported a long-term bull market. During the mid to late stages of these markets is when volatility will have consistently higher readings. For some investors the first sign of higher readings could cause many to become concerned to early. At which point, they sell their stocks and assume a major market correction is going to take place. However, because there is so much demand for stocks and the market is in the middle of secular bull market, they realize that the volatility readings were inaccurate. Once this takes place, they stop paying attention to the early warning signs that it is providing. As a result, many investors would continue to buy stocks well into 2000, thinking that the worst was over, when in fact it had only just began. What this example shows, is that in some cases, the different volatility indexes can provide changes in sentiment several years in advance.
The challenge is being able to make an accurate interpretation of what these different indicators mean. This is why you must always correlate the different readings from these indicators, with one another and compare them with the trend of what is actually occurring.
Investor Intelligence Surveys
Investors intelligence surveys are when you are looking to see how bullish or bearish various financial newsletter editors / writers are about the overall market conditions. Like what was discussed earlier in the section about how various news headlines will reflect the overall mood of the crowd. The same thing applies for financial news letter editors, whose views about the future of the markets will reflect the overall emotions of traders and investors. Where, extreme readings of investor intelligence surveys will tell you if the overall conditions of the markets could be overbought or oversold. There have been many different academic studies performed over the years, which highlight how extreme amount of bullishness or bearishness from investors will often affect the markets. This is because when such instances occur, they are at points that the forces of supply and demand can no longer maintain the current trend. At which point, it is only a matter of time until you see a change in the major trends of the markets. A good example of the overall usefulness of investor intelligence surveys can be seen in a study conducted by Journal of Economic Perspectives. Where, the authors would engage in a study to see the effects that investor sentiment would have on the equity markets. The way that this was accomplished was by examining the effect that investor sentiment would have on prices, by looking at the consequences that high / low sentiment would have on each individual stock. This allowed the author to see the true effects that sentiment would have on an individual stock vs. The overall market averages. The results were that the extreme amounts of sentiment do have a dramatic impact on the price of the individual stocks. With the author concluding, "We show that it is quite possible to measure investor sentiment, and that waves of sentiment have clearly discernible, important, and regular effects on individual firms and on the stock market as a whole. In particular, stocks that are difficult to arbitrage or to value are most affected by sentiment."
This is significant because it shows that by using different investor sentiment tools at extreme points; do have an effect on the price of individual stocks and the markets. It is also important to note, that those stocks that are most affected by volatility, are those that investors have trouble understanding and determining an accurate valuation such as: technology. This is helps to explain why at major turning points for the markets, the sentiment for these stocks will rise or fall more dramatically.
Understanding Investor Sentiment
During the late 1950's and early 1960's the idea of using investors' intelligence surveys to predict the overall direction of the markets was fairly new. In 1963, Abe Cohen began to conduct investor intelligence surveys to determine the overall optimism or pessimism of the crowd. Then, during the 1980's his predecessor Michael Burke began to take this number to a new level. Where, they would monitor over 140 different newsletters to determine the overall levels of optimism or pessimism of newsletter editors.
The way it works is the views of these different newsletter editors / writers represent possible buying and selling from the general public, who uses these resources a tool to aid them in their investment decisions. During times when these newsletter editors are becoming overly bullish or bearish is when you are entering the accumulation / distribution phase of the economic cycle. This is where the total amounts of buying or selling have become extreme and the markets are due for healthy correction (at the very least), to restore the natural balance. In general, investors' intelligence surveys will look at the total percentage of bull and bears. When you see the overall amounts of bullishness or bearishness rise above 55%, this is a sign that investor sentiment is becoming to extreme, where to many investors are either overly optimistic or pessimistic. A decline in the bullish or bearish levels of sentiment to the 35% mark; would indicate that that the total amount of investor sentiment has declined so much that the conditions or the markets are becoming oversold / overbought. For example, if investor sentiment is currently sitting at 60% of the total amount of investors bearish about the market, 35% are bullish about the markets and 5% are neutral. This is a sign that the markets have become oversold, where the high readings of negative sentiment and the low readings of positive sentiment would confirm these extreme views. The neutral readings are largely ignored, with contrarians mainly focused on the views of both extremes.
Investor Sentiment Tools
There are several different tools that are used to determine the overall amounts of optimism / pessimism to include: the Investors Intelligence Sentiment Index, the American Association of Individual Investors Sentiment Survey (AAII) and the Nova / Ursa Ratio. The Investors Intelligence Sentiment Survey conducts a weekly survey of different newsletter editors / writers about their overall views on the markets. This information is then reported to investors on their website and in the financial publications weekly. The way it works, is when this indicator rises to extreme levels it is useful in helping to identify when changes in the trends of the markets are taking place. Extreme levels on this index would be seen when the overall levels of bullishness or bearishness are at 25%. This is important because once the different views of investors reach this level; it is an indication that a major market reversal could be eminent. For example, during the market corrections of 1996 and 1997, the overall levels of bullishness would fall to 25%. This would signal that the crowd had become to overly pessimistic, as such extreme levels were associated with a sharp rise in fear. As a result, the Dow Jones Industrial Average would form a bottom and would break through its all time high, after these readings were seen. This is significant because it shows how once the overall amounts of sentiment becomes to extreme; this can be used as a way to identify possible medium to short-term opportunities.
The American Association of Individual Investors Sentiment Survey (AAII)
The American Association of Individual Investors Sentiment Survey (AAII) is: a survey that takes the views of individual investors, about their future expectations for the markets. This is different from many of the other investor sentiment tools because, they are taking the views of an actual investor vs. newsletter editors / writers or professional traders. Every Friday they publish a weekly survey of the overall views that are being reflected from the investing public. In general, this indicator has often been used as a tool to help confirm the overall mood of the crowd. However, it has been known to be more of lagging indicator. This is because the views of the individual investor are reflecting what has happened with the economy and the markets. When you are in a secular bull or bear market, they reflect this attitude. This is problematic because a part of all contrarian thinking is taking the view that the general public is wrong about their investment decisions. As a result, this indicator will not reflect the extreme views of sentiment in comparison with the other investor intelligence surveys. That being said, many traders and investors will use the information from the AAII to confirm what is being seen from other surveys. This helps to provide more clarity in the overall buy or sell signals that are being seen with major changes in the market trends.
The Nova / Ursa Ratio
The Nova / Ursa ratio are two mutual funds that track the performance of the S&P 500. The Nova fund mirrors the performance of the S&P 500, where if the index rises, it will follow suit by rising the same amount. While, the Ursa fund inversely follows the S&P 500, where, the value of the fund will increase the same amount that the index falls. If the average rises, then the value of the fund will decline by the same amount. Both funds are owned by Rydex and are designed to provide professional traders, another way that they can be able to profit off of the short-term fluctuations in the market. The way that they help traders to do this is through use derivatives, with various put and call strategies used to mirror the performance of the average. To have an account with the company requires large minimum balances must be maintained at all times. As a result, they attract professional traders and sophisticated investors. When you see extreme amount of purchases on either the Nova or Ursa fund, this can be used to help show how the crowd is overly optimistic or pessimistic. For example, in October 1998 there were fears that the Russian Financial Crisis would spread to the rest of the world. On October 8th, the markets would hit long-term support and begin to steadily rise. This is important because the Nova / Ursa ratio was showing the highest amounts of investor pessimism ever seen. Over the next week the market would continue to rise, yet the ratio would remain the same. This indicated that the crowd was overly pessimistic and did not have any kind of faith in the rally that was taking place. Then, the Federal Reserve unexpectedly announced that they were dramatically cutting interest rates and the market average would breakthrough their all time highs by January 1999.
What this example shows; is that the Nova / Ursa Ratio can be used to identify extreme amounts of sentiment that are occurring in the markets. Once this takes place, is when you have the possibility of seeing violent moves to the up or downside, as extreme readings would confirm changes in supply and demand.
Drawbacks of Using Investor Intelligence Surveys
Investor intelligence surveys have the same drawback as other contrarian indicators discussed earlier; they provide early / false signals. This problematic for investors because when these different early signals occur, investors could assume that the markets are over / undervalued too early. At which point, they begin liquidating their long short positions and may engage in more bearish / bullish strategies such as call or put buying. The problem with using this strategy is that there are times when the indicator will show that sentiment levels are at extreme points, yet the market could continue to move in the same direction. If an investor is shorting a stock without using any kind of buy stop (this is the opposite of sell stop that is used in shorting), they could see significant losses as the stock can appreciate quickly. To avoid this kind of situation, it is important to remember, that some readings from this indicator could take a few days or they could take several weeks to become reality.
A second drawback that many investors and traders will run into when using different intelligence surveys are: neutral readings from the various indicators. Like what was stated earlier, these various surveys are very useful in helping to identify extreme amounts of optimism or pessimism. However, there are going to be times that these surveys will show that the investors, traders, and newsletter writers / editors are not overly optimistic or pessimistic. When this happens it means that the surveys are confirming the trend that is currently in place. For some investors this is problematic, because they try to use these indicators to determine short-term swings in the market. At which point, it is only a matter of time until they begin to see the market move in the opposite direction. This is because they are trying to overly interpret the different investor sentiment surveys. Therefore, to effectively utilize this tool means that you must monitor these indicators when extreme changes in trend are occurring.
Short Interest
Whenever a buy or sell order is entered, by an investor / trader, federal regulations require that all trades are marked as: buy long or open sell short. This information is then compiled by the different stock exchanges and reported the Securities and Exchange Commission. The total amount of short interest is: reported to the SEC no later than four business days after the 15th of each month. The popular view of short interest is that, the process of shorting is so complicated that only the most sophisticated investors would have the knowledge / experience to make money in this area of investing.
This is because there are number of obstacles to include: having to borrow money to conduct the trade (a process known as trading on margin), brokerage firm restrictions on the availability to short certain stocks and the possibility that the losses could be unlimited. As a result, many investors will assume that when short interest is rising or falling, it will reflect what views the smart money has about the markets going forward. However, this false perception of how to accurately read short interest; means that most investors will follow what the crowd is doing. At which point, it is only a matter of time until these investors and traders will be caught on the wrong end of the markets. This is because short interest represents the potential buying at some point in time. What happens is, when an investor is shorting a stock they are using margin to borrow the stock from another investor who purchased it long, at the same brokerage firm / clearing house. In the agreement that is signed by everyone prior to trading with margin, there is a clause that says the stock certificate can be loaned out for shorting as long as it replaced.
Because of this, those who are shorting stock must buy the stock back to close out the transaction. The profit or loss is made from the point they borrow the stock (initiate the short position) to the point they purchase the shares back. In contrarian thinking, when the short interest rises or falls to extreme levels, this is an indication that the many traders have become overly optimistic / pessimistic about the markets or a stock.
An example as to how effective short interest is in predicting market returns can be seen in a study conducted in the Journal of Banking and Finance, where they study the overall effects that short interest would have on Canadian stock prices between 1998 and 2002. What researchers found, is that those stocks which had large amount of short interest, were able to see above average price appreciation. This is because of such extreme amounts of pessimism or optimism in the stock. Those companies that were more thinly traded or smaller, were more subject to violent up and down swings, when sentiment indicators has risen to such levels.
This is significant, because it shows how the total amounts of short interest in the markets or a particular stock, can be used to determine if prices have moved to an extreme point.
Short Interest Ratio
When short interest is reported to the public, it will list the total amounts of shares that are shorted in each stock that trades on the different exchanges. This number is usually reported to investors in the form of a percentage of the total amount of shares that are shorted, in relation to the number of shares outstanding (commonly called the float).
For example, if the NASDAQ is reporting that Google has a short interest of 30%, this would mean that there are total of 30% of shares in the stock that are shorted.
To determine more accurately the total amounts of shorting that are taking place, many traders will use another number to assist them: the short interest ratio. The short ratio measures what is known as the total amount of days to cover. This is where you are looking at how long it would take all of the outstanding shorts to complete their buying (a process known as buy to cover). The way that this number is calculated is: by taking the total number shares that are sold short and dividing the stock by it into average trading volume. This ratio is used in conjunction with the short interest numbers, to determine the overall extent that traders are optimistic or pessimistic. Where, extreme readings of high / low short interest and the high short / low interest ratio; would provide the best opportunities for possible trades. For example, let's say that Ford has a 60% short interest and a short ratio of 21.00. While, GE has a short interest of 10% and short ratio of: 1.58. In this particular situation, the trader who is looking for long contrarian opportunities will go with Ford. This is because of the high short interest and short interest ratio are: indicating that if all of the different short positions decided to cover their position at the same time, it would take 21 days to completely close out all of these trades.
What this shows, is that the short interest and the short interest ratio, can be used to confirm as well as identify extreme imbalances in the forces of supply and demand. Where, it will tell you if there are pent up amounts of potential buying or lack there of.
Correlation
All of the different contrarian indicators are effective at identifying changes in the overall trends of the markets. However, to overly rely on one particular indicator or index to make investment decisions is: foolish and will eventually result in major losses. The reason why is when the markets are going between the different extremes of fear and greed, they will often overshoot. As a result, all of the different indicators will show that the markets are severely overbought or oversold. Yet, they may continue with current trend for the next several days to several weeks. At which point, a major reversal will take place. This is when the different contrarian indicators are effective. During the middle of secular bull or bear markets, these indicators are not very useful, other than to confirm that the overall opinions between the bulls and the bears are split. This means, that the markets need continue with their current trend for a while longer, until the forces of supply and demand become imbalanced between the buyers / sellers. At which point, a major change in the trend will occur.
Analyzing the different Trading Strategies
The different contrarian tools mentioned earlier can be used in conjunction with technical and fundamental analysis to determine if stock prices are overbought or oversold. The way it works is the various contrarian indicators can determine if market conditions are overbought / sold. At which point, you can then examine the different contrarian readings, in conjunction with what either the various ideas of technical or fundamental analysis are: saying about a particular stock. This helps investors and traders to be able to make more prudent investment decisions, by purchasing those companies that have the greatest potential to benefit from: such extreme amounts of sentiment. Then, after the investment has performed well for a period of time and investors have become overly optimistic, they can sell when it is at its peak value. This is allowing prudent investors and traders, the opportunity to maximize their profits, while reducing the risks as much as possible.
Using Contrarian Thinking with Technical Analysis
When you are using the different ideas of contrarian thinking in conjunction with technical analysis, you are evaluating the forces of supply and demand in different ways. Where, both can be used to compliment the overall buy / sell signals on a particular stock or within the markets themselves. In many ways, combining the ideas of contrarian thinking with the different technical analysis tools can provide a trading strategy, which is not used by many traders or investors. At which point, it is possible to quietly take advantage of the different market irregularities. This is because many academic studies have claimed that it is impossible to combine both forms of analysis to have superior results. A good example of this can be seen with a study that was conducted on both forms of thinking in the Journal of Consumer Research. Where they found that, "Momentum and contrarian investors differed on a number of dimensions including price expectations, age, experience, raw performance, risk propensity, cognitive style, knowledge calibration, and strategy adaptively."
What the authors did not tell you is that they conducted their surveys on stock brokers. These are nothing more than salesman; who sell what the brokerage firm tells them to. This is significant, because it underscores how in the real world, prudent traders are using the combination of contrarian strategies, with others to quietly make a small fortune. At the same time, the authors and the investors that believe these statistics wonder why their investments do not out perform the markets. This is because they are overlooking the fact that aside from interviewing specific brokers about their thoughts, each way of valuing the investments has ideas that can be used to identify changes in the markets. One of the keys to being able to outperforming the market averages and reducing your risks as much as possible is: to create a strategy that can work well with proven tools / indicators. Otherwise, you will be subject to the emotions / forces of the markets. An example of this can be seen with comments from Ben Graham where he said, "There are no sure and easy paths to riches on Wall Street or anywhere else. In our own stock market experience and observation, extending over 50 years, we have not known a single person who has consistently or lastingly made money by following the market. We do not hesitate to declare that this approach is fallacious as it is popular."
This is significant because it shows that randomly following the markets and not seeking out ways to improve your overall returns, means that you are destined fail.
Trading using Contrarian Indicators and Technical Analysis in the Real World
One of the biggest problems with using any kind of strategy is: that most do not provide any type of consistency to accurately predict changes in the trends of the markets. To always remain on the right side of the stock or the markets, requires first establishing the long-term trend of the markets. The way that this would be established is by using the different moving averages in conjunction with the put call ratio on the CBOE. To determine the short, medium and long-term trends of the markets requires: examining how the different moving indicators are reacting to one another. A moving average is: the average price of the stock over a given period of time. To confirm the different trends of the stock or the markets, you would want to evaluate how the moving averages are performing in relation to the price of the stock. Where, you want to monitor the slope of the moving averages and the reaction of the stock, when one crosses through the others.
This is important, because when the stock is making crossovers at critical points, it is often at various support or resistance levels. The support level is: the price that the sellers of the stock will become exhausted and it can not drop any further. The resistance level is: when the price of the stock has risen so much, that the buyers have become exhausted and the price can not go any higher. It is at both key resistance / support levels, that technical as well as contrarian indicators will indicate severe changes in the overall supply and demand picture of buyers to sellers. For example, at end of a long-term bull market, the price of the stock tops out at an all time high. It then retests its support level and the high. At which point, the price of the stock will decline and move back toward support. All the moving averages have went from a an upward sloping pattern to a downward trend, with the 10 day moving average crossing through the 50 day and 200 day moving average.
When this kind of situation occurs, it is a sign that a change had taken place in the trend of the markets, as the different moving averages are confirming this change.
The use of the Moving Averages and the Put Call Ratio to determine the Market Conditions
Determining Bullish Trends / Sentiment
An effective way to evaluate the valuations of the different market averages is to compare them with each other. In this example, we will use the ETF that tracks the Dow Jones Industrial Average (symbol: DIA). Looking at the put call ratio of the average, it is clear that it has been through a variety of extremes over the last two years. With the put call ratio rising: to as high as 3.0 and it has been as low as .5. This is significant, because both areas could be used to confirm changes in the overall trends of the markets. For example in late 2009, the put call ratio on DIA would rise to a high of 2.50. This followed a period after the average had formed V shaped a bottom in March 2009. Many traders and investors were still nervous about the markets and the rise that had taken place in the averages. As a result, they would begin to purchase puts to protect their downside risk. This would signal that the amounts of sentiment were so extreme, that a change had taken place in the two-year downtrend. When you compare what the high put call ratio is showing in relation with the different technical indicators, it is clear that as sentiment was becoming more negative, the 10 day moving average became positive and broke through the 50 day moving average in late March / early April. Then, in July the different moving averages would move through the 200 day moving average. This is significant, because when a short tem moving average (such as the 10 day moving average) and a medium term moving average (such as the 50 day moving average), breaks through a long-term moving average (such as the 200 day moving average), it means that there has been a change in the major long-term trend of the markets.
In the case of DIA, the technical indicators would show that a long-term change in the trend of the markets has taken place. At the same time, the put call ratio would continue to rise eventually hitting, 2.40 in late August / Early September.
Looking at this information, the prudent investor and trader would see that as the Dow Jones Industrial Average was rising, the overall amounts of fear were not dropping.
Now that the trend in the Dow is confirmed, we must confirm the overall trend of the markets. In this particular case, we will be confirming the underlying trend of the Dow Jones Industrial with that of the NASDAQ 100. Like what was stated earlier, when ever you are making any kind of investment decisions you must correlate the trend, with other markets. This will increase the odds of identifying those companies that are trading at a significant discount in relation to their value. In this example we will look at the NASDAQ 100 (symbol: QQQQ), during the same time frame that a bullish trend was established on the Dow Jones Industrial Average. In March 2009, QQQQ would form a V shaped bottom at $26.00 per share.
This would be accompanied by a sharp spike in the put call ratio to 1.50.
Over the next several months, the ETF would rise to as high as $37.50. During this time, the 10 moving average would begin sloping upward and would break through the 50 day along with 200 day moving average. However, during early July, the ETF would experience a decline that would cause prices to fall to long-term support and the 200 day moving average, at $35.00 per share. This is significant, because when you see a correction in the index and it finds support at it's long-term moving average; it means that it is a good time to be investing in long positions. The reason why, is because the indexes were not able to easily break through the 200 day moving average.
When you put this in conjunction with the put call ratio, it is showing that investors / traders are somewhat pessimistic about prospects for the stock going forward. As this number would continue to rise to 2.00 by mid August, while the prices on the average continued increase during the same time.
In this particular scenario, the prudent trader would be aggressively purchasing stocks after the successful retest of the 200 day moving average. This is because the NASDAQ mirrored the same V shaped bottom on the Dow Jones Industrial Average; and all of the different moving averages would show, that there was a change in the long-term trends of the markets. In July, when prices declined to the 200 day moving average and support levels, then began to rise. This was a sign, that they were moving higher, as the put call ratio would rise from early July to Mid August. At which point, the price of the ETF would climb to $50.00 by April 2010. What this shows, is that using the contrarian indicators such as the put call ratio, can help to provide more clarity, as to what is on the minds of most traders and investors.
Where, the different moving averages are showing a major change in the trends of the markets, while the put call ratio is indicating that the total amounts of fear are rising along with price of the stock. When this kind of divergence is spotted, it means that the prudent investor / trader should take advantage of these opportunities. Using the example of QQQQ, had a prudent trader entered the ETF the between $35.00 and $37.00 per share, they would have seen a potential profit ranging from 35.1% to 42.8% in less than one year (this is before commissions and the cost of the trade). This is significant because it highlights how using contrarian tools can be able to spot outstanding buys, when many are risk adverse.
Determining Bearish Trends / Sentiment
Determining the emergence of bearish trends would require seeing low amounts of sentiment and the different moving averages sloping downward. Where, the 10 day moving average would easily cross over through the 50 day moving average and 200 day moving average. In technical analysis, when you see a breakthrough of: the 200 day moving average when all of the different indicators are sloping downward, it is sign that a bear market could be possibly emerging or is already in place. A good example of this occurred with the S&P 500 in October 2008 (symbol: SPY), when the put call ratio would fall to 1.15.
This was the lowest reading for the year and it would indicate that traders and investors were to optimistic. In the case of the S&P 500, the downward trend was established when the 10 day and 50 day moving averages would move through the 200 day moving average in December 2007. By October 2008, the down trend was still in place, yet a bear rally would take occur, taking the average up to 1,000.
This is significant, because it shows how the index has confirmed that the bear market is still in place. Yet, many traders are overly optimistic, causing a bear rally. For the prudent trader and investor, this would mean the opportunity to be able to begin taking short positions.
Now that a bearish trend has been established is one market, the key is being able to identify this signal with other market averages. Using the NASDAQ 100 (symbol: QQQQ) from the same time frame, the put call ratio declined from 4.00 less than 1.00.
This is significant because it shows how the overall amounts sentiment went from one extreme to another, in less than one month. Then, when you look at the technical indicators it would show that the long-term trend of the average is bearish. This occurred when the 10 day along with the 50 day moving averages would slope downward and cross through the 200 day moving average, at $47.00 in December 2007. By October 2008, the price of QQQQ had reached $27.50 per share and a bear rally was taking place, as shares would eventually rise to $33.00. During this brief period of the short-term bullish trend, the 10 day moving average would slope upward, while remaining well below the 50 and 200 day moving average. This was a sign that the long-term trend of the markets was bearish, as prices were never able to make any kind of cross over of the 200 day moving average. For prudent traders and investors, this would provide an opportunity to short the ETF towards the end of the bear rally. Where, you would monitor the different resistance levels. In this particular case, QQQQ would rise to $33.00, which would be where the short-term resistance was at.
The fact that it could not significantly break through this level indicated, that the buyers were becoming exhausted. The large extremes on the put call ratio would confirm the underlying bearish trend in the markets. This means that most logical entry points for some kind of short position would have been between $33.00 and $28.00 per shares. If a prudent trader or investor had engaged in a short position at these levels, they would have seen the price of the ETF decline between 12.0% and 24.2% (before commission or the cost of the trade), with shares falling to $25.00 by late November / early December.
This is significant, because it shows how the low readings from the put call ratios on the S&P 500 and QQQQ, were indicating that the downward trend in the markets would continue. The technical indicators were showing that the bear rally that was being seen in the index and the ETF were short lived. This is because; the 10 day moving average came no where near the descending 50 and 200 day moving averages.
When you see such a scenario, it is indicating that the bearish trend will remain in place, until the forces of supply and demand become more imbalanced. What this shows, is how the prudent trader / investor can be able to make significant profits, when others are fearful about the economic situation / the markets.
Protecting Yourself
The markets are always changing to reflect future expectations for stock prices and the economy. What makes trading them so difficult, is being able to predict the different changes will occur before it is realized in the actual economy. This is because, the expectations for future earnings will be reflected in stock prices, which are usually looking out anywhere between 6 to 12 months down the road. As a result, the general public and economist will not know if an economic slowdown / recovery has taken place, until many months into the event. A good example of this can be seen with the recent economic recession that began in December 2007. Throughout much of the economic slowdown, economists were not ready to officially claim that the U.S. was in the middle of the worst economic recession since 1982. It was not until, December 2, 2008; that economists declared that the United States was in a recession that began in December 2007.
This had taken place after the Lehman Brothers bankruptcy and the markets had imploded.
What this shows, is that sometimes changes could have occurred to the economy and we may not know it. This is why it is important to remember that any kind of trading strategy is not going to be 100% accurate. Where, there are going to be times that all the different indicators may show that a stock or index is a strong buy / sell. However, some erroneous situation could come out of nowhere that could completely change the supply and demand picture. This is the biggest risk of investing in the stock markets.
To protect yourself against these kinds of situations it is imperative that you are using either a sell / buy stop. Like what was touched on earlier, a stop order is set at around the same time you are entering the buy / open short order. This is: a separate sell / buy order that will sell / buy the stock if it rises or falls to a given level. During the course of trading this is useful in limiting the overall amounts of risk in the stock. One way that you could set the different sell stops is at points where there is the possibility of major changes in the trends of the markets, by placing them below the 50 day moving average. Using the two previous examples of QQQQ, some kind of stop could have been placed below or above the 50 day moving average, allowing for an investor / trader to receive better returns, while limiting their risk. In the case of QQQQ, a trade could take place to buy the ETF between $32.00 and $35.00. The sell stop could have been placed bellow the 50 day moving average, which was $32.50.
As the ETF continued to trade higher, you could have adjusted the sell stop upward to limit the overall amounts of risk. This strategy would have allowed a trader / investor to ride the average until it reached the 52-week high. At which point, they could have exited the stock around $50.00 or they could seen; if it will go higher and kept adjusting the sell stop upward. When you look at how this strategy would have worked, the initial downside at the time of purchasing the stock was between 3.9% and 4.1%. The upside potential of this trade would have been between: 35.1% to 42.8% if one had continued to adjust the sell stop upward behind the 50-week moving average, they would have more than likely set their sell stop at about 43.80 (which is below the 50-week moving average at the time). Had they missed the opportunity to sell the stock at $47.50, the sell stop would have sold the ETF for them at $44.80.
The total return before commissions and the cost of the trade would be between 16.2% and 28.0%. What this shows, is that when you are accounting for risk using this strategy and continually adjusting upward to reflect this risk, the odds increase dramatically that you will see a greater profit than the average investor / trader.
The case second example involving QQQQ represents how the use of a buy stop could have limited the overall amounts of risk, while participating in the potential opportunity to make money in the downside of the markets. In the above example, QQQQ would rally between $27.50 and $33.00, during October 2008. At the same time, the indifference from the crowd would indicate that the current trend was still in place. In this situation, a buy stop would be placed at 6%, which is from $29.15 to $34.98. As the price of the ETF continued to slope downward, the buy stop would begin to flatten out at $27.00 in December. In this particular case, initially placing the buy stop below the 50 day moving average would provide a level of risk that is too high. As the price of the ETF began to decline is when placing the buy stop would be effective. When this occurred, it meant that the overall levels of risks would remain the same, because you kept adjusting your buy stop with the declines in the ETF. Using the entry points of between $27.50 and $33.00 on the short position, the initial amounts of risk in the trade would remain.
As the rate of decent slowed towards the end of November / December. Where, once the price of the ETF reached $25.00%, the downside risk would have remained the same at 6%. This is significant because it shows how continually limiting your overall amounts of risk on volatile trades can produce superior results. For this particular trading strategy to be effective, requires limiting your losses or potential losses as much as possible. As a result, the prudent trader / investor would place the buy stop at a predetermined percentage of: 5% to 6%. In the case with QQQQ, the initial buy stop would be placed between $29.15 and $34.98. This was determined by taking 6% from the execution price on the trade. As the price of the ETF continued to decline, this buy stop of 6% would need to be adjusted at least once a week. By the time the price of the ETF reached $25.00, the buy stop would have been placed at $26.50. The maximum potential profit from this trade would have been between 12.0% and 24.2% if the short position was covered at $25.00. However, if the buy stop was used to close out the transaction, then the profit would have been in the range of: .5% to 19.6%.
What this shows, is that even during the middle of bear markets, there are opportunities for investors / traders to be able to profit off of the fear that is taking place. The indifference from investors in the put call ratio, underscores that a secular bear market is in place, while the bear rally would provide the opportunity to see significant profits. Through the use of a buy stop, you are accounting for the overall amounts of risk and then adjusting the risk, with the declines in the price of the stock. As a result, this strategy allows prudent traders and investors to maximize their profits, while reducing risks as much as possible.
Commissions and Fees
The total risks vs. reward projections that were provided above did not include the various commissions and fees that are charged by the brokerage firm / clearing house, for executing the trade. Over the last several years, the overall amounts of commissions and fees charged for executing trades vary dramatically. In some cases, you have the full service firms that will make recommendations and can charge up to a maximum amount (under the law) of: 5% of the total transaction cost. In some cases, this can mean that the potential profits have been reduced, as the price of the stock must rise or fall more to cover these costs.
There are also many online brokerage firms that will give large discounts to those who are more actively trading the markets. Where, their fees can range from $7.99 to $9.99 for the cost of the trade. Since the objective is to keep the cost of the trade as low as possible, this strategy would most effectively be utilized through an online broker. As a result, the total % for conducting at trade worth $1,000.00 would be .99% of percent. Therefore, depending upon the size the trade a logical assumption would be to calculate the cost of executing the trade to be about .1%. This means that for any kind of potential profit or loss that is calculated, you would include a total of 2%.
The Times when you are not Investing
There are going to be times when using this trading strategy will mean that a percentage of the portfolio would need to remain in cash. The best way to achieve the highest rates of interest and liquidity would be to move into a Treasury mutual fund. This is a mutual fund that will invest in a portfolio of Treasury securities. All brokerage firms will have access to these kinds of funds and the interest / dividends received from the different investments, can be swept into these types of funds. This will allow you to always have ready access to cash, during those times that a number of possible trading opportunities have been identified. In general, this strategy is preferable compared to directly investing in Treasuries, municipal bonds or Certificates of Deposit through the use of laddering. This is when you are increasing the overall amount of interest that is being received by the portfolio, by spreading out the overall maturities and interest rates of the bonds / CDs.
The problem with using this kind of strategy is: when you are trading you more than likely will have large portions of your portfolio tied up in the various investments, which can not be liquidated right away. As a result, you stand the chance of missing good possible trading opportunities, because too much of the cash is tied up in various bonds / CDs. When you are using a Treasury mutual fund, you can receive the same benefit of laddering without tying up the available cash.
Now, you must determine the total amount of cash that will remain in the portfolio at all times. In general, most aggressive trading strategies encourage you to invest at least 90% of your assets while leaving 10% in some kind of cash investment.
The problem with using this kind of strategy, is that you investing too much of your cash into the markets at one single point in time. When this happens, it means that the odds increase that there is the possibility your timing could be off on the markets. Where, you could increase the total number of losses by investing too much into a variety of areas at the same time. To reduce this possibility, the prudent trader / investor will keep a larger portion of their assets in cash, usually in the range of 20% to 30% of their portfolio.
They will then, select different investments based on a clear signal of the trend and the market conditions. As they do this over the course of time, they are allocating their cash in a variety of sectors and companies. At which point, the risks to the portfolio is reduced by having diversification in a number of different companies and areas. While, the sell / buy stops would ensure that these investors / traders are not left holding on to those companies that see major reversals. This means that there will be times that the total amount of cash that is allocated to a particular strategy could increase during times of extreme volatility. Where, the major market averages could be going through a change in trends, but we may not fully know it until later. An example of this, can be seen with someone who is taking bullish or bearish positions during times when the markets are going through reversals. In this kind of situation, many of the different positions that have been performing very well would more than likely see execution prices at the sell / buy stops. When this happens, there are one of two scenarios that traders / investors could engage in: to wait for a clear trend or they can purchase calls / puts for protection. Many traders and investors will allow the cash to build up in the Treasury mutual fund during these kinds of situations. This is because they are unsure as to if there has been a change in the long-term trend, and they are waiting a little longer to see what direction the markets are headed. The purchases of select calls / puts are: usually completed on major index such as the S & P. 500. The idea is that when you see a consistency of: hitting all of the sell / buy stops at the same time; it is an indication that a major change has taken place in the trend. To be prepared for these changes, means that you must do the opposite of what is taking place. One of the least risky ways to do this without using a large amount of capital is: to purchase calls / puts on the major indexes. If the current trend continues, then the trader / investor will be able to profit from the large amounts of volatility. What this shows, is that an important part of any trading strategy is to understand how you will manage the portfolio during those times when major changes could be occurring. The use of: the various stops, the wait / see approach during such changes or purchasing select calls / puts; offers investors / traders the opportunity to see greater profits, while reducing risks as much as possible. This is the key to being able to see consistent returns that will outperform the major market averages year in and year out.
Testing the Trading Strategy
The strategy of using the different contrarian indicators in conjunction with technical analysis to: identify reversals, possible entry / exit points in the stock and confirm the trend have all shown to be an effective trading strategy, over the short to medium term. However, to fully determine if using this kind of strategy would be effective in a variety of different markets and conditions; requires that you test the effectiveness of this strategy, using various market averages around the world. To do this we will look at how well this strategy would perform on the London FTSE 100 and in comparison to the gold prices. This will be accomplished by examining the performance of the average with a component of the average. Then, the price of gold will be studied through the use of the Gold Trust Spider (symbol: GLD), which mirrors the movements of the price of gold.
The London FTSE 100 and QQQQ
During this portion of the analysis we will be looking at how the London FTSE 100 is performing in conjunction with the NASDAQ 100 (symbol: QQQQ).
To examine the overall amounts of sentiment on the London FTSE 100 and QQQQ, we will use the various financial headlines as the contrarian indicator. This is because finding the total amount of put call ratio was challenging. Since contrarian analysis can use more than one tool, the use of the different headlines will confirm the underlying emotions of the crowd. In April 2008, the FTSE would appear to be reversing from the long-term down trend that it established in December 2007. This is when the 10 day and 50 day moving averages crossed through the 200 day moving average. In April, the FTSE would rise above the 200 day moving, nearly reaching the 6,250 level. However, the 10 day and 50 day moving averages failed to confirm the cross over of the 200 day moving average. Where, both would remain negative, while the average would briefly remain above the 200 day moving average.
This would signal that the bearish trend that was established in December 2007, was going to continue. When you look at the different news headlines, it is clear that the overall amounts of sentiment are negative among investors and traders. This is because the FTSE took a significant decline in March following the U.S. Government's rescue of Bear Stearns.
As a result, the overall amount of pessimism became very high which could be confirmed by the various news articles talking about the future direction of the markets. A good example of this can be seen with a news article from Reuters, which quoted a leading financial expert that the average was going to 5,300. Then, when the average began to rise and the 10 / 50 day moving averages, it did not confirm the cross over, this would be an obvious sign that the crowd was overly optimistic.
At which point, the prudent trader / investor would have a clear signal that the current down trend that was established in December 2007 is still in place.
When you compare the trend and the sentiment of QQQQ with that of the FTSE 100, it is clear that it is mirroring what is happening with the index in April 2008. Where, the price of the ETF would climb to $50.00. This follows a severe decline in the index, as a crossover occurred with the 10 day and 50 day moving averages through the 200 day moving average, from December 2008 to February 2008. The bear rally that took place in April 2008 would see: the 10 day moving average cross through the 50 day moving average. At which point, shares would top out at $50.00 and fail to cross over the 200 day moving average. What this shows, is that bearish trend on the FTSE 100 and the stock was confirmed.
Over the short-term, the overall amounts of sentiment changed, as many in the press would publish predictions as to where the index was headed. While, this did occur, the time frame that these predictions were released means that sentiment had become to negative, which would spark a bear rally on the indexes. In this particular situation the prudent trader / investor would begin implementing an open short position, once the average began to decline at $50.00. This is the resistance level in the average, as the failure to break through it would indicate a continuation of the trend. The ideal entry points for a short position would be between: $50.00 and $45.00. A buy stop would then be placed at a 6% increase in the price of the ETF, which would be between $53.00 and $47.70. The 6% mark was selected because the 50 day moving average is below the execution price of the open short position. The buy stop could have been adjusted downward, as the price of the stock was declining. Using the 6% rule on the buy stop, it would have been adjusted to around $34.454. In September 2008, the price of the ETF would decline to $30.00, before reversing and rallying.
The profit that would have been realized using this strategy and buying to cover at the lowest point; would have resulted in a profit of 23.0% to 27.2% (before commissions and the cost of the trade). If the buy stop was executed the profit would have been between 33.3% and 40.0% (before commissions and the cost of the trade). What this portion of the strategy shows, is that it confirms how the use of different contrarian indicators, in conjunction with technical analysis can be used to identify the market conditions and the overall sentiment. In the above example, this amount of negative sentiment could have been used to find a possible short opportunity over the medium term, while keeping the total risk in the stock to 6%.
To see if this strategy is confirming the other signals requires looking at something that performs inversely to the equity markets. The price of gold has historically been a safe have for investors and traders, who are nervous. As a result, it will moves in the opposite direction of the equity markets, this can be useful in confirming the negative or positive trends that are occurring. One way to evaluate the overall impact that markets are having on the price of gold is through the use the Spider Gold Trust Shares (symbol: GLD). This is an ETF that will track the movement of the price of gold. When you apply the same timeline from the above example with this ETF; it is clear it is showing a bullish trend, as the ETF would climb to $100.00 during March 2008. This is because of fears surrounding the Bear Stearns bailout.
At which point, a correction would take place in the ETF, with the 10 and 50 day moving averages turning negative, then crossing through each other. At the same time, the FTSE 100 and QQQQ were finishing their bear rallies, while the correction was over in GLD. Where, shares would find support at $86.00, above the 200 day moving average. This is significant, because when you take the negative economic headlines of the Bear Stearns rescue, this seem like a normal reaction. As the overall amounts of fear would climb, once the details of the bail out were disclosed. The reversal would confirm the signal seen on the FTSE 100 and QQQQ, as the overall amounts of fear became too high, causing oversold conditions over the short-term.
The Effectiveness of Using this Strategy
The strategy of using different moving averages and technical indicators to determine the overall trends of the markets and a particular stock can be effective. This is because it involves looking for extreme amounts of pessimism or optimism, which can be used to identify possible trading opportunities, because of changes in supply and demand. Where, traders and investors are looking at both factors to identify irregularities. In this particular strategy, the use of: the put call ratio; in conjunction with the headlines from the press and the different moving averages have shown to be effective at identify good possible trading / investing opportunities. Where, the possible medium to long-term profits off of the portfolio would be between .5% and 42.8% . While, the downside risks would be limited to 6.0%, through the use of the different sell / buy stops. What makes this trading strategy so effective is the fact, that it can be used as a way to unemotionally evaluate what is occurring in the markets and a stock. At which point, you can begin positioning with certainty that the odds are high, that you will more than likely see a significant profit because of this strategy. The reason why is: it encompasses one key element that many Wall Street analysts and traders refuse to talk about, the times that they are wrong. This is problematic because not having a way to reduce risk, during these times can destroy the profits that were made in the portfolio, as one unexpected event can lead to dramatic losses. To prevent this situation, requires establishing a way to reduce losses as much as possible. The use of the buy / sell stops is what make this strategy superior, to the others that traders are using.
Using Contrarian Thinking with Fundamental Analysis
Fundamental analysis is when you are analyzing various pieces of economic / financial information to determine if the markets or a stock is overbought / oversold. This would include: examining earnings forecasts, debt, various economic indicators, management and the forces of supply / demand upon the stock. The idea with this form of analysis is: to use this information as a way to identify the long-term effects, that the different valuation methods and economic factors will have on the markets / stock prices. As a result, this form of analysis has proven to be a popular way of investing. This is because a number of different studies have shown that fundamental analysis can provide significant improvements to the overall return in the portfolio. A good example of this can be seen with a study conducted in Accounting Review, where they analyzed how this would help improve a businesses overall bottom line. This was accomplished by the traditional principals of accounting that the most successful businesses embrace to include: examining the revenues, inventories, accounts receivables and other factors. They found, that those companies that were the most profitable exhibited conservative strategies when it came to profitability and how they would finance growth. Where, they would maintain large cash reserves and low amounts of debt. At which point, researchers then complied a list of publically traded companies that matched these different principals. The results were: that those companies who demonstrated these different characteristics showed a 13.9% return. Those companies that performed the best, would met the different qualification standards, but would have something significant to report about their financial status (such as they are raising earnings or repurchasing stock).
This is significant, because it shows how using various fundamental principals can identify those companies that are over / undervalued.
In fundamental analysis, there are number of different tools that are used by investors / traders to identify good trading opportunities the most notable would include: the price earning ratio, the current ratio and the consistency of the dividend pay out. The price to earnings ratio (PE) is when: you are analyzing the price of the average and are comparing it with earnings of the all the companies that are members of the index. To determine if it is trading a discount or it is expensive in relation to the price of the stock. This is calculated by taking the current price of the average and dividing it into the earnings per share of all the different companies. In general, when you see the PE ratio at low reading of 15 or below, it is a sign that the price of the stock is trading at a discount. While, those kinds of readings that are above 20, would indicate the price of stock is expensive in relations to its earnings.
Another way to effectively determine if the markets are over / undervalued is by combining the above mentioned fundamental indicators with the different contrarian tools. The two will be able to provide a clearer picture as to if the equity markets and the price of the stock are over / undervalued. This will help to improve the overall decision making process as to which investments make the most sense, financially speaking.
Determining Bullish Trades Using Fundamental Analysis and Sentiment
To determine the overall amounts of bullish sentiment, you must first examine the trend of the economy by looking at various leading economic indicators. These are economic numbers / reports that will highlight the overall strength or weakness in the economy, which can help to gauge the underlying trends. Two key leading economic indicators would be: manufacturing activity (as reported through ISM Manufacturing Index) and the services data (as reported by the ISM Services Index). These two indicators are useful in determining if the overall amounts of business activity in the economy are: improving or declining. It is conducted by the Institute for Supply Management, which has been using the surveys since 1915, to determine the overall purchasing plans and views that managers will have for their businesses going forward.
The way that this index is interpreted is on a scale, where 50 is major dividing line. This means that when either index reports a reading of 50 or above; it is a sign that either the manufacturing or services sectors are expanding / declining. While, a reading between 50 and 43 would indicate that the economy is begin to either starting to expand or is starting to contract. A reading below 43 would indicate that the economy is in a recession.
When you are analyzing these two surveys you want to compare the number with the relative trend of the past numbers. Where, you are examining the overall strength or weakness of the number in relation with the current number. For example, if both the ISM Manufacturing and Services Sectors began to show readings of 47.1 and 49.2, after three years of consistent readings above 50. This would indicate that the economy is beginning to moderate and that some kind of economic slowdown could be taking shape. The same thing applies when the economy is coming out of recession, only this time the reading between 43 and 50, would mean that the economy is beginning expand. For example, in June 2009 the U.S. economy began to slowly recover from the worst recession that has occurred since the Great Depression. Where, the ISM Manufacturing Index had begun a reversal starting in April, by the June the indicator was showing a reading of 44.8.
While, the ISM Services Index, had been growing consistently for nine consecutive months posting a reading of 47.0 during the same time.
This confirms the overall trend that is in place, with an economic recovery that slowly beginning to occur in April 2009. When the ISM Manufacturing Index crossed over 43.0 in June, this was a sign that a change in the long-term trend of the economic cycle was beginning to take place. To confirm this signal with a contrarian indicator, you would compare the underlying trends in manufacturing and the service sectors to the put call ratio on the S & P. 500 (symbol: SPY). During the same time that the ISM Manufacturing and Service Indexes were showing improvements, the put call ratio one the S&P 500 rose to 1.76.
This is significant, because the put call ratio is confirming the improvement in manufacturing and the service sectors of the economy. Once both indicators were beginning to show improvements, the put call ratio would rise on the S&P 500 at the same time. Together, these two elements show that the long-term trend in the economy has reversed and is slowly beginning to expand. While the put call ratio says, that this expansion could be at an extreme point of supply and demand. Where, investors and traders are fearful enough about the future, that they are actively purchasing puts. This is a sign that the forces of supply and demand have been pushed to such an extreme, that investors are throwing away great businesses with strong fundamentals. As a result, the prudent investor would want to seek out those companies that offer the opportunity for significant medium to long-term price appreciation.
Now that the underlying positive reversal in the economy has been identified by the various ISM surveys, you want to correlate what is happening with other major market averages. To do this we will examine Dow Jones Industrial Average and compare the economic situation with that of the markets. When looking at the price of the ETF during June 2009, it had fallen dramatically since October 2007 when it was trading at over $130.00.
In March 2009, the price would reach a multi-year low of $65.00.
In June 2009, shares had rallied and were trading between $80.00 and $85.00 per share.
The PE ratio would show that the average was trading at a significant valuation of 14 on the trailing PE ratio.
The forward PE ratio would reflect earnings relative to the companies that compose the average. When you apply this range the average, you would have a forward PE ratio ranging from: 10.27 to 12.47.
What this shows, is that DIA is within the predetermined ranges for good valuations, with the average trading at trailing PE of 14.00. While, the forward PE is showing that multiples are in from 10.27 to 12.47. What all of this shows: is that from a valuation standpoint, the markets would have good medium to long-term opportunities.
This is because the PE ratios are highlighting how the price of stock is trading below it actual valuation. Then, when combine this with the high amounts of negative sentiment in the ETF; since it was heading toward the March lows, indicates how the negative sentiment is affecting valuations. Where, the put call ratio would rise to as high as 1.20, indicating that the markets were becoming severely oversold.
For the prudent investor, this would provide an excellent opportunity, as purchasing shares between $80.00 and $85.00 would have shown a return of: 29.41% to 37.5% (before commissions and the cost of the trade) by May 2010 (as the price would rise to $130.00).
Protecting Yourself
Like what was mentioned previously, no investment strategy is 100% accurate. This means that there are going to be times that the trend of economy, the contrarian indicators and the different valuations methods indicate that the price of the stock is severely undervalued. Yet, something unusual occurs that could cause a complete shift in all of these different variables. To protect yourself against this kind of uncertainty, it is advisable to use to a sell stop to reduce the risk as much as possible. Since, the focus is more medium to long-term, you must account for the fact that the price of the stock could decline before moving higher. The best way to achieve this objective is to set the sell stop 10% below the execution price and then continue to move the sell stop up to where it is 10% below the current markets price. In the case of DIA the sell stop would have been initially placed between $55.00 and $60.00, depending upon the execution price. You would have then, moved the sell stop up to eventually $122.00 per share.
If the sell stop had been executed, the profit would have been 87.6%. What the above example shows, is that using the different fundamental indicators in conjunction with contrarian tools, can be effective at helping to identify medium to long-term trading opportunities in the markets. Using this strategy, the total amount of risk would be limited to 10%, through the use of the sell stop. While, the prudent investor would have realized one out of two, long-term profit situations occurring, because of this strategy. If they sold the ETF at or near the 52-week high of $130.00, they would have more than likely realized a potential profit was 100%.
However, if they kept adjusting the sell stop upward, as the price of the ETF was increasing, they would have seen a percentage gain 87.6%. This is significant; because it underscores how using a combination approach of comparing various fundamental and contrarian indicators, can be effective at identify opportunities in the markets.
Determining Bearish Trades Using Fundamental Analysis and Sentiment
The strategy of comparing the different fundamental and technical indicators can be effective at identifying when the stock or the markets are becoming overvalued. The is because you are examining the underlying trends that are taking place in the economy using the ISM surveys, examining the various sentiment and then looking at these factors within the company to determine if it is expensive. For example, in June / July 2008 the QQQQ would touch resistance level of $47.00.
It would then begin climbing, as it appeared the sharp wave of selling that had begun in May was beginning to run its course.
At the time, many economists were unsure if the economic conditions were a mild slowdown or something more severe. To determine the overall trends of the economy you would use the ISM surveys. In July 2008, the number for the month a June unexpectedly increased to 50.2.
This follows four months where the index was below 50, yet above 43. While, the ISM Services Index was at 48.2 for the month of June, this follows a zig zag pattern that the index was following between 43.0 and 50.0 since January 2008.
During the same time, the put call ratio was rising dramatically on the NASDAQ as it would reach a high of 2.00.
These high amounts of fear would correspond with the overall amounts of caution seen from the sharp increase in energy prices and the challenges facing the real estate market. What all of this shows, is that the as economy is contracting the volatility in the ISM surveys are reflecting the challenges that are being faced by businesses, with one index trading back and fourth between 43.0 and 50.00. While, the others would show that it is continuing to become worse. The negative sentiment would signal that any kind of moves in the markets will be short-term in nature, because sentiment has become so extreme. Yet, the economic picture from the leading economic indicators in manufacturing and services, show that the economy is facing severe challenges going forward. When you place this information in conjunction with the economic backdrop, it is clear that the ISM and high amounts of negative sentiment are telling investors to sell their long positions or begin shorting.
Now that the negative trend has been identified in the economy and on the NASDAQ, it must be correlated with another major average. In this particular case, you would want to find an index that would be affected by the up and down swings that can take place in the economy. For example, the S&P 500 (symbol: SPY) would touch a low of 110 in March. It would then begin to rally, with it trading at $130.00 in June.
Part of the reason for this was because of the better than expected first quarter numbers that the companies were reporting in April. To most investors this would seem like a good buying opportunity, given the fact that many companies had positive comments and better than expected numbers. However, when you look at the PE ratio for the index of 18.00, indicates that average is overpriced.
This is because the historical valuations of the average are above 15.00. Then, when you consider the fact that many economists were unsure if the U.S. economy was in a recession, meant that from a fundamentalist standpoint the markets are still expensive.
While, the put call ratio falling to .75, would indicate that the sentiment from traders and investors was overly optimistic. This is confirming what was seen on the NASDAQ, as the overall amounts of negative sentiment would mean that SPY would fall to $70.00 by December.
Where, the average would follow a similar pattern as the NASDAQ.
What all of this shows, is that purchasing stocks should have been avoided by those investors who were seek to purchase them for their long-term possibilities. This is because the PE ratio indicated that earnings were declining. This would automatically disqualify an investment for further consideration under classical valuation methods. However, a prudent trader might use this information to short the average.
The ideal entry point would be between $125.00 and $130.00. If a trader had engaged in such actions they would have seen of potential profit between 44.0% and 57.1% (before commission / the cost of the trade).
To limit the risk a buy stop could be placed at 6%, from the execution price. The reason why 6% was selected is: shorting using fundamental analysis presents more risks than purchasing long. Since, the ETF does not qualify, to be purchased long under traditional valuation methods; means that it could be very volatile. As a result, a tighter buy stop was selected to limit the amount of risk as much as possible. You would then adjust the buy stop downward to protect the profit. This would have meant that the buy stop would have been eventually adjusted to $74.20.
If the buy stop was executed, the potential profit that could have been realized from such a transaction would have been between 40.6% and 42.9% (before commissions / cost of the trade).
What all of this shows is that using the valuation method in conjunction with contrarian indicators, can help investors and traders identify those stocks to avoid / possibly short. In the case of SPY, the prudent trader could have used the information to realize a maximum potential profit of 44.0%. If the buy stop was executed as it was adjusted downward, the potential profit would have been between 40.6% and 42.9%. The total downside risk for engaging in such a transaction would have been 6%.
The Times when you are not Investing
During those times that you are not investing, you should have the dividend and the cash sitting in a Treasury mutual fund. The reason why, is because you can maintain the account with your brokerage firm and it can easily be liquidated. These two factors are important to ensuring that you are liquid when you identify good trading opportunities. As a general rule you would want to keep between 20 to 30% of your portfolio invested in cash or cash equivalents. During those times when different buy / sell positions may be harder to identify, this amount will increase. The reason why, is there could times that determining the direction of the economy could be difficult or the investor / trader are unsure about what to. When this kind of situation occurs, it is prudent to leave the cash sitting in the Treasury mutual fund, until the market conditions are more favorable.
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