In this week’s issue of the Market Slice, we discuss if there is too much pessimism in the trading market, what it has to do with your investment portfolio, and more!
What Contrarians Are Saying About a Market Crash
For several weeks, we’ve been looking at market volatility.
Markets have been trading in a relatively wide range, but in general we are seeing lower highs and lower lows, which could indicate a coming market reversal. And all the major indexes are off close to 5% from their all-time highs as of a month ago.
A growing number of analysts are concerned that this is the start of a larger correction. Here are some of the concerns:
- This year’s spike in inflation is proving a lot less transitory that the Fed expected.
- Supply chains remain badly disrupted.
- Economic growth is slowing, particularly in Asia where the failures of massive firms like Evergrande threaten to destabilize things further.
- Energy shocks are suddenly happening all over the world.
It’s understandable that more and more people are now asking: Is the bull market over? Is a market correction imminent? Is this “contrarian” view now the consensus?
Or more to the point: when everyone is saying things are headed south, which way are things likely to be going?
Last week Macro Strategist David Hunter told Adam Taggart of Wealthion that there is simply too much pessimism in the market right now to support the thesis of an imminent reversal. He’s calling for a blow-off top in the weeks and months ahead. But don’t get too optimistic based on Hunter’s view… he sees a massive collapse in equity values ahead. Just not yet… as a true contrarian, he will be watching for the “all in” moment, when virtually everyone thinks the market can only go higher. (Historically, market crashes tend to occur at the height of investor optimism. See the article on The Trading Psychology and Contrarianism below.)
As an antidote against complacency or a false sense of security regarding the economic outlook, Hunter says this:
“Economic fragility and inflation combined with massive leverage is a disaster waiting to happen.”
From a long-term macro perspective, this is still our view:
The question is, what to do in the meantime?
FFR Trading has a team of Strategists who will help you avoid the pitfalls of conventional thinking with your investment portfolio. Get out of line… following conventional wisdom is a recipe for disaster! Call our Strategy team today for a no-risk investment portfolio strategy review. 1-800-883-0524.
Trading Contrary Factors: A Bad Idea?
As we have pointed out many times, there is a big difference between long-term investing, and trading. Whether you are a position trader with an outlook for weeks or even months, or a day trader looking at 1-minute bars, your mindset is completely different from that of a buy-and-hold investor.
Contrary investing can be a solid approach. Similar to value investing, which looks for stocks with share prices lower than the intrinsic value of the company, contrary investors generally believe that the market overreacts to good and bad news.
But where value investing compares current pricing to the underlying value of the company, the contrary approach focuses on going against the current market sentiment. John Jagerson and Wade Hansen, of StrategicTrader.com, offer this assessment of a contrarian method:
Analysts use contrarian indicators to try to find extremes in market sentiment that can serve as potential turning points where bullish, or bearish, momentum will break out and start moving the opposite direction.
One contrarian indicator we like is the number of S&P 500 components that are trading above their 200-day simple moving average (SMA).
Percentage of S&P 500 Stocks Above 200-Day Moving Average (S5TH) — Chart Source: TradingView
If you compare the times in Fig. 3 when the indicator moved above 80% in 2012, 2018 and 2020 (A, D and E) with the movement of the S&P 500 in Fig. 4 (A, D and E), you will see the indicator did a good job identifying moments when the market got too bullish and ended up experiencing a bearish correction.
Article source: https://www.yahoo.com/now/contrarian-crash-indicator-000107564.html
The catch with this approach is that it still leaves you, as an individual trader, in the position of having to identify the right time to enter the trades identified with this kind of method.
This puts you into the category of “market timing,” and it is a very dangerous place to go as a retail trader. Even when you are right on direction, you can be a little bit off on timing, and still lose a bundle.
If you find yourself drawn to contrary analysis, consider applying it in your long-term trading activities. But think twice – three time, even! – before trading against the trend in shorter time frames. This is from the dummies™ folks:
“Contrarian traders are fighting the trend, and that can work against them sometimes. This style favors people who know a market inside and out so that they know when to move against it.”
Have you seen this video yet? It details how Joe Duffy has won on 16 out of 16 trades this year based on his trend-following approach. Using option spreads to limit risk and profit from trading into predictable market moves, Duffy is up over 70% so far this year. After you watch the video, give us a call for all the details. 1-800-883-0524.
Trading Psychology and Contrarianism
What kind of mindset is behind the contrarian approach?
In his classic book, Trading for a Living, Dr. Alexander Elder has this to say about mass psychology:
When you go long or short in the financial markets, you join a huge crowd of traders. They buy and sell, trying to profit from their opinions about future prices. Their fear and greed create huge waves of mass optimism and pessimism. These psychological tides, as strong as the tides in the ocean, sweep the markets, causing them to rise or fall. Crowds are big and strong – it is expensive to argue with them.
Despite this powerful truth, many traders feel compelled to “prove themselves” by trading against the crowd. While this approach can yield big wins, it can also lead to disastrous losses, as Elder points out.
What Drives Non-conformity in Traders?
First, let’s look at what academics say about conformity:
Conformity is defined as the tendency to change one’s beliefs and/or behaviors in ways consistent with the group norm or standard.
Put simply, humans tend to conform to the beliefs and behaviors of others. Conformity means yielding to perceived group pressure, even when no direct request or command has been made. In this regard, it is different from compliance, which is doing what others request or ask you to do (even if you prefer not to), and obedience (which is following orders).
When it comes to investing, following the herd can lead to missing out on the biggest opportunities… after all, if the crowd is there already, the lion’s share of the gains may have already been realized.
This is what we saw during the GameStop fiasco. Those who jumped on early made fantastic gains as the Reddit train got rolling… but thousands of traders got creamed by buying after the best part of the move was over… and in the ensuing correction.
But the short sellers – the contrarians who tried to buck the trend – fared even worse.
Contrarian investors are often the biggest winners, when they are right. Contrarian traders, however, have to be extremely knowledgeable in the markets they are trading. Otherwise they risk getting crushed by the powerful wave of market opinion.
The most prominent example of a contrarian investor is Warren Buffett. “Be fearful when others are greedy, and greedy when others are fearful” is one of his most famous quotes and sums up his approach to contrarian investing.
Do you have a trusted trading coach who can help you think through your market positions? FFR’s Strategy Team is here to help you! Call 1-800-883-024, or click the button below, for your no-risk strategy assessment.
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