In Defense Of Contrarian and Sentiment Analysis

Bullish sentiment turned extreme the day of the jobs report last week and has stayed that way. I have read a number of critiques of sentiment and contrarian analysis in recent days because the market has yet to turn lower. Let me start by saying that there are no indicators that will give you the top and bottom of the market to the day. If that is what you are looking for you will be disappointed.

Not only will contrarian and sentiment analysis not call tops and bottoms perfectly, there are times where it will fail completely. The reason I use contrarian and sentiment analysis is to tell me approximately where we are in a rally or in a decline. When optimism is extreme I know we are likely in the latter part of the rally. This latter part of the rally can continue, but the risk/reward of being long is not very favorable. I much prefer to put my neck on the line when there is extreme pessimism.

Many people are bullish right now and are getting defensive when they are being faced with bearish facts.  When Barron's has a Dow 15,000 spread the same week Nouriel Roubini turns bullish its not likely a great sign for the market. But rather than accepting these facts many bulls would prefer to take pot shots at those pointing it out.

There are a long list of warning signs that make me believe that this is not the best time to be taking a lot of risk. We can grind higher for a while but when a correction comes it will likely take away all the gains swiftly. Its possible that my analysis is wrong this time and we go to straight to Dow 15,000. But over time investing aggressively at times of extreme pessimism and being defensive when there is extreme optimism should continue to serve me well.


leopardtrader said...

You make sense in your argument. Unfortunately indicators or too far too fast do not signal top or bottom. Neither contrarian indicators as Roubini, Barron Round table...LOL automatically signal to top or bottom as well.
The fact is that underlying conditions signal top/bottom. That takes serious knowledge of the market (skill) and experience. Many traders/investors out there do not really posses the skill or knowhow required. They just jump in  thinking that indicators or the media will put them on the right part.
On the current rally, we were correct on the main wave since late sept, 2010. It is still very much in play and no sign yet of a major correction other than the usual shallow pullbacks normal in a huge rally.

Onlooker from Troy said...

No major correction since Sep 2010?  You must have made a typo.

Anybody who follows Tsachy regularly knows that he doesn't use just sentiment, or any other single element, to make his market decisions.  It's just one tool in the box to help guide him.  And I haven't seen any others who do it much better; over a long period of time, not just the latest lucky flash in the pan.

Onlooker from Troy said...

Excellent commentary as usual Tsachy.  There's so much ignorance on this topic out there.  You set it straight very nicely; for those who really want to listen.

Tsachy Mishal said...

The more things change the more they stay the same. Most people just don't want to learn and that's why these cycles repeat.

frank r said...

The correction will definitely take away the gains swiftly, but I don't think that correction will happen soon. I suspect we have several more months to go. Same as in 2010 (top around April) and 2011 (top around May). Small investors are just waking up to the idea that it is once again "safe" to invest in stocks and it will be at least several months before they are fully onboard. You only pull the tent down after ALL the suckers are inside. I'll wait for Tschay to throw in the towel and become a screaming bull before I'm ready to call a top.

Seriously, fiscal stimulus is starting to be removed this year and the Republicans have zero incentive to help Obama out by voting for more stimulus. The states can't keep kicking the can down the road and so are forced to make cutbacks. Housing is approaching a bottom in many area but won't turnaround any time soon. Corporate profits are high, but cost of capital is low. Somebody out there has surely put 2+2 together and figured out they can snatch somebody else's hefty profits by building new supply using this low-cost capital, and that should drive profits down due to competition. There are deflationary winds blowing from Europe and China and the dollar will remain strong, so no export boom beyond what we've seen so far. My theory is that the current euphoria is due simply to gloom fatigue, and will fade at some point. Negative earnings or employment report, won't take much to send the fast money heading for the exits. Retail investors who just finished tiptoeing back in will panic as always. The Fed has already promised the moon (zero rates to 2014), so no help coming from that quarter. I'm just sorry I unloaded my excess stocks at SP500=1285 rather than holding on for higher prices. I'm now at my baseline stock allocation and so don't have anything left to sell unless prices get crazy.

Tsachy Mishal said...

To refresh your memory: in 2011 we saw a greater than 5% correction in March. In 2010 January saw a greater than 5% correction.