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Sentiment Analysis
The Smart Profits Report: Issue #378
Wednesday, December 13, 2006
Sentiment Analysis: Incorporating Contrarian Investing in Your Trading & Financial Endeavors
By D.R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
The editorial staff of one of the country’s most prestigious newsletters has just taken me out back to the proverbial woodshed. And for a sound beating at that.
“D.R., are you sure about this analysis that the dollar is going up? Every other analyst that we’ve talked to says the dollar is going to crash. This is really going against the crowd.” “But I thought this was a contrarian newsletter,” I protested. “A crashing dollar is contrarian,” shot back the reply. “Apparently not today,” I thought to myself.
The above discussion is largely fictionalized to help bring home a point. You see, when everyone is on board with a certain point of view, the smart money is already leaning the other way. And that’s one of the key tenets of sentiment analysis.
Let’s take a look at one of the most basic tools of sentiment analysis - consensus opinion - and how you can use it today to protect or build your own portfolio.
The Dollar and Sentiment Analysis
On December 5, the dollar made an 18-month low.
Dollar sentiment was (and still is) at ridiculously low levels. Every talking head and analyst in the land has been kicking the good old greenback square in the ribs.
In fact, The Economist, that venerable British weekly, had a picture on its cover showing George Washington from the U.S. dollar bill looking down with his mouth agape, accompanied by the headline: “The falling dollar.”
So when I did my analysis of where the dollar is likely headed, two things stuck out:
- Everybody and his brother thinks the dollar is going down.
- We are less than 5% away from the all-time lows established in the trade-weighted dollar index.
Anytime we get sensational gloom-and-doom news magazine covers, together with overwhelming consensus opinion, I get excited about market turns. Because history shows us that when everyone thinks a market can only go one way, it usually heads the other way - and in a hurry.
The Power of Contrarian Investing
Since the aforementioned discussion on the dollar, it has risen almost 2%. This has prompted headlines like: “Euro Collapses In Corrective Selloff.” The power of contrarian investing and trading shows off again.
Sentiment analysis is a fairly blunt tool when it comes to timing market turns (though it may have nailed a turn in the dollar pretty closely). However, it is one of the most powerful predictive tools available. If you’d like to learn more about contrarian investing and the basic precepts of this facet of sentiment analysis, please see the Smart Profits Cribsheet below.
So how can you incorporate contrarian investing in your trading and investing activities? Here are some guidelines:
- Don’t start selling out of your positions just because consensus opinions start to move to extremes and news weeklies start to run cover stories. BUT… these useful indicators should prompt you to make sure your stops are in the right place and that you take extra care in opening new positions.
- Remember that consensus opinion is generally a poor timing tool. Consensus can gel for quite some time before the smart money takes over. Use good technical and price analysis tools to sharpen your timing of market tops and bottoms. It’s best to wait for the price to start moving in your favor, instead of trying (or hoping) to pick a top or bottom.
Good Trading,
D.R. Barton, Jr.
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Today’s Smart Profits Cribsheet
- I also talked about the use of sentiment analysis along with technical charting of the developments of crude oil prices in Smart Profits #329, The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices.
- Two classic “must-read” books for all traders and investors (not just contrarians) are: “Extraordinary Popular Delusions and the Madness of Crowds” by Charles MacKay and “Devil Take the Hindmost: A History of Financial Speculation” by Edward Chancellor. You’ve got just enough time to stick them on your Christmas gift list!
- Good technical and sentiment analysis will always be trumped by big news in the short term. If you’d like to take a look at some reasons why you might want to consider adding an “early exit” contingency to your trading or investing plan, check out Smart Profits #332, Stop Loss: Three Reasons to Get Out of a Trade Before it Hits Your Trailing Stop.
Related Articles:
- Contrarian Investing: The Best Investment Strategy You Should Use Today
- Contrarian Investing Strategy: The Most Profitable Way To Invest In 2007
- Technical Analysis Indicators: Harness The Power Of Leading Indicators And Bollinger Bands
The Chart of the Week
Level 3 Communications (Nasdaq: LVLT) has three tough technical indicators working against it going into today’s trading session:
- It tested a major resistance level at $6 on Monday and was rejected.
- The stock finished Monday’s session weakly.
- Momentum is down sin the last test of the $6 area. Look for a pullback from here.
