Bears, Contrarians and the Crowd

Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average.
–Garrison Keillor


These days, everyone wants to be a contrarian. 

That absurd statement leads us to taking a look at Contrary Sentiment (and other indicators). This highly misunderstood aspect of Technical Analysis can be a source of confusion to long term investors and short term traders alike.

First off, s consider how many people like to think of themselves as not part of the crowd. Surveys show that 80% of people with automobile licenses consider themselves to be "above average drivers."

Like the improbable children of Lake Wobegon, this is not statistically  possible.

But it reveals something of Human nature: People like to consider themselves separate from — or better yet, superior to — the crowd. At the same time, our experience has been that most people unknowingly act with the crowd.

It is an inherent biological trait, one that has developed over millions of years. There is safety in numbers. In all of those Mutual of Omaha Wild Kingdom episodes I watched as a kid, it was always the gazelle on the outskirts of the herd that got taken by the lions.

The safety and success of going with the flow can be summed up by John Maynard Keynes: "Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally."   There is much truth to that.

While many people like to think of themselves as contrarians, the reality is that in the markets, the crowd is what moves the indices. Consider how many Wall Street cliches are a recognition of the power of the masses:

-Don’t fight the tape
-The trend is your friend
- Never catch the falling knife
- A rising tide lifts all boats

Each of these aphorisms distilled to its essence are alluding to the power of crowds. Both directly and indirectly, the masses of buyers (or sellers) are what move markets. People forget the simple truism that markets go higher when there are more buyers than sellers, and lower whent there are more sellers than buyers.

Which brings us to today’s look at sentiment. One of the things I keep hearing is that there are "too many Bears for the market to go down." That statement is true when Bearish sentiment reaches a true extreme; it can also be true for very short term counter trend rallies.

But just because sentiment is negative or positive does not mean markets automatically must go in the opposite  direction. Helene Meisler looked at some past periods where negative sentiment was pretty consistent — and martkets went down anyway. Specifically, she looked at the Investor’s Intelligence readings
from the early 1970s, specifically 1973-74:

"From March 1974, the DJIA
traded between 846 and 800, roughly a 5% range. In that same time frame, the
percentage of bearish newsletter advisers rose steadily from a low of 27% to
60%. The DJIA finally broke 800 in July 1974 year; by then, the bears were
already at 60%. They climbed further to a peak of 69.6%.

In other words, the bears were right. And look at how they stayed bearish for
the whole decline.
The current reading for the percentage of bears is quite high at 34.7%,
although it is well off its peak reading of a few weeks ago. But note that it
has been in this mid-30s range since mid-June.

When folks ask me, as they often do, where sentiment is now, I must report that it is bearish. It has been bearish and it has not changed. Yet all those bears haven’t helped the market rally longer than a handful of days at a time.

Perhaps there are too many bears out there. Perhaps all these bears will lead to a lasting rally one day, but all those bears didn’t help the market in 1974 and so far it hasn’t helped the market since June.

When I see the number of stocks making new highs increase and volume increase along with it, I will be happy to jump into the bull camp. But for now I continue to be part of the bear consensus."

That the crowd has become negative as the economy is cooling and inflation is still present may not be a great contrary indicator; Perhaps it generates a pop lasting a few weeks. But as we have seen in history, the crowd is typically correct — until they reach great extremes.

There are all too many pseudo-contrarians who do not understand how (and when) these sentiment indicators work; I saw one that claimed the Housing posts on this blog were a buy signal for the Homebuilders.

Compare that with the "Home Sweet Home" on the cover of Time magazine in June 2005 as a sell signal for the home builders.

Investor’s Intelligence Bearish Percentage and DJIA, 1973-74      

Investor’s Intelligence Bearish Percentage 2003-present      34326


As Helene’s charts above show, we are nowhere near extreme levels of sentiment that have in the past, reliably produced major reversals or even counter trend rallies.


Confessions of a Consensus Bear
Helene Meisler, 8/25/2006 9:00 AM EDT

Home Sweet Home
Time magazine, June 13, 2005,16641,1101050613,00.html

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