What exactly is "contrarian investment" and "contrarian analysis"? How and why does it work?
Essentially, contrarian analysis looks for potential buying and selling strength by gauging investor expectations. In other words, by the time it becomes public knowledge that a large number of people are "bullish" on a particular stock, a substantial amount of that stock has already been bought, and there might not be much additional demand. This depleted buying strength is then much more likely to be overwhelmed by even a small amount of selling strength that will push the stock lower.
The opposite is also true: by the time everyone is "bearish," the selling strength has been mostly depleted, and even a small amount of buying can push the stock higher.
In general, the analysis of "market sentiment", when used in conjunction with other indicators such as technicals and fundamentals, is most effective at yielding profitable results.
True contrarian investing does not mean blindly buying a stock or index simply because no one else likes it. It should be expected that negative sentiment would surround a poorly performing security. Although by some definitions, an investor might be considered a "contrarian" if he buys any out-of-favor securities. But that doesn't necessarily mean they will reverse and move higher. There is probably a very good reason why a declining stock has been declining, and negative sentiment alone is not enough to predict when it will go back up. It only indicates how much potential buying strength exists for such stock. Only when there is reason to believe that buying strength is returning, would the stock be expected to recover. Until then, it will likely continue its descent. After all, even greatly reduced selling strength will keep a stock moving lower as long as it exceeds the buying strength.
Contrarians often find themselves in a position opposite to that taken by the bulk of the investing public. It is not as though they believe "the crowd" is apt to be wrong, but rather that the opinions of the majority tend to represent capital that has already been allocated. Therefore even if a strong company reports high earnings, the stock price will not move any higher if it has reached a peak in its popularity and there is no one left to buy additional shares.
A good source of sentiment data is the Consensus Index of Bullish Market Opinion of stock index futures traders. This survey polls futures traders to find out how many of them are bullish, and the results are particularly telling for upcoming stock market direction. A very high reading means that a large percentage of those polled are bullish and have already done the bulk of their buying. In other words, it probably marks a time when buying strength might be weaker than selling strength. It also works in the opposite direction: a low number of stock index bulls suggests a lot of selling has been completed and there probably isn't going to be enough selling strength to offset even a small amount of buying strength. Therfore stocks are more likely to move up.
Another tool for assessing market sentiment are put/call ratios in the options markets. A put is a bet on a decline, and a call is a bet on an advance. When there is an excessive amount of bullish investment (buying of "calls") made on equities, the buying strength is probably significantly reduced. The opposite is true when there is a large number of bearish investment (buying of "puts"), which generally means the selling strength has diminished. Therefore, when there is a very large number of puts compared to calls (a high put/call ratio), there are many investors who have made leveraged bets that stocks are going to decline. At that point, these investors have already sold a great deal of their stock positions, which means there is a lack of selling strength. Then, even slightly more buying strength will overwhelm the remaining sellers and push the market back up. This is why the overall market tends to rally following high equity put/call ratios.
In summary: by the time that virtually everyone is bullish, it is likely that buying strength is depleted and any declines will probably be significant. Conversely, by the time that virtually everyone is bearish, the selling strength has probably been depleted and a major market move upward is likely in the very near future.
However, the analysis of market sentiment sentiment should not be viewed in isolation. Simply buying a stock because it is out of favor may be easy, but it's a dangerous activity. So use sentiment judiciously and in conjunction with appropriate technical data.
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