- 1997: Volume 6, No. 6 Contrarian Investing and the Individual Investor: Putting it to Work for You!

We are frequently asked what "contrarian analysis" is and why it works. Very simply, the contrarian analysis we conduct at Investment Research Institute 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. It is important to realize that sentiment analysis, 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. By some definitions, an investor might be considered a "contrarian" if he buys 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 tells us how much potential buying strength exists on a stock. Only when there is reason to believe that buying strength is returning should we expect a recovery in the stock. Until then, it will likely continue its descent. After all, even exceptionally depleted selling strength will keep a stock moving lower as long as it exceeds the offsetting 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 we believe "the crowd" is apt to be wrong, but rather their opinions represent capital that has already been allocated. For example, if you hear that a large percentage of the people who follow IBM are bullish on the stock, the bulk of IBM shares have probably already been bought. Often we see such bullish sentiment exhibited in the options market, because demand for IBM call options would be considerably greater than the demand for IBM put options in this case. Such skewed demand is one of the best representations of depleted buying strength.

If shortly thereafter, IBM releases a very good earnings report and the stock goes down, many people will be surprised. "How could such a popular stock go down after a fantastic earnings report?" the pundits will ask-but that's just the point. Even if a great company reports great 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.

Another example of sentiment data we follow is the Consensus Index of bullish market opinion of stock index futures traders (Consensus is located in Kansas City). This survey polls futures traders to find out how many of them are bullish, and the specific readings are particularly telling for upcoming stock market direction. We can assume that 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 likely marks a time when the buying strength might not be greater than selling strength. It also works in the opposite direction. A very low number of stock index bulls as rated by Consensus suggests a great deal of the selling has been completed, and there probably isn't going to be enough selling strength to balance out even the slightest bit of buying strength. So, stocks are much more likely to go up. It's that simple, but it's a lonely game. After the 1987 crash when bearish sentiment was at a peak, you might have been laughed at if you were bullish, but you would have been right. Such was the case with IRI President Bernie Schaeffer, who used sentiment analysis to call the market top in August 1987 and then turned bullish at the exact market bottom after the crash.

Many of our readers are aware of the sentiment tool known as put/call ratios. A put is a bet on a decline, and a call is a bet on an advance. The most effective way we have found to follow put/call ratios is by monitoring equity options on the CBOE (Chicago Board Options Exchange). When there is an excessive amount of bullish bets (call buying) made on equities, the buying strength has probably been somewhat depleted. The opposite is true when there is a large number of bearish bets (put buying), which generally means the selling strength has faded. Therefore, when there is an exorbitantly 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.

How high would a put/call ratio have to be to predict a major move up in stocks? On any day, if the ratio of equity puts to equity calls is greater than 0.60, history has shown that the market should go up. Every day, the CBOE announces several totals for option volume, including the total volume for equity puts and calls (you'll have to do the math yourself). To obtain this option information, contact the CBOE at 1-888-3VOLUME. You can also look at this data by using a 10-unit moving average. Simply add up the last 10 days' readings and divide by 10. When this number goes above 0.47, the market is set to rally. Should the 10-day average exceed 0.50, the market is set for a major move.

Let's review our notion of contrarian investing. By the time you see that virtually everyone is bullish, you can bet that buying strength is likely depleted and any declines are apt to be significant. Conversely, by the time you see that virtually everyone is bearish, the selling strength has probably been depleted and a major market move upward is probable in the very near future. Remember that the only condition that can push a stock higher is when buyers outnumber sellers. Thus, the stock of an overloved company is not likely to rally regardless of how strong the company is. Finally, sentiment analysis should not be viewed in a vacuum. Simply buying a security because it is out of favor may be easy, but it's an exercise in futility. Using sentiment analysis in conjunction with technical data is certainly more effective-and more profitable.

Mike Oyster is Senior Quantitative Analyst for Investment Research Institute. Investment Research Institute is a leader in options trading education and publisher of the widely circulated The Option Advisor newsletter. For more information on the firm's unique approach, check out President Bernie Schaeffer's new book, The Option Advisor: Wealth-Building Techniques Using Equity and Index Options. The book was released by John Wiley & Sons Publishing, Inc. in October.