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Contrarian Investing Strategy

The Smart Profits Report: Issue #384
Friday, January 5, 2007

Contrarian Investing Strategy: The Most Profitable Way To Invest In 2007
By Jim Stanton
Technical Analyst, Mt. Vernon Research

As a technical analyst, I’m not an advocate of simply trying to pick tops or bottoms. That’s because stocks can stay overbought or oversold for much longer than you think (the current impressive rally and the dot-com boom in 1999 are good examples).

But technical indicators can provide some valuable clues in picking the right time to go against the crowd. And a contrarian investing strategy can prove quite rewarding.

Signs Of A Short-Term Market Reversal

One of the first signs you should look for is higher-than-average volume. When the majority of players are bearish on a beaten-down stock (or index), the stock is probably setting up for at least a short-term reversal. Here’s how it works:

  • Phase I: Aggressive traders are the first to step in, which causes the stock to stabilize and possibly start moving higher.
  • Phase II: If the rally continues, the increased buying will catch the eye of other professional and momentum traders, and they start buying. This increases the demand for the stock.
  • Phase III: The final people to jump on the bandwagon are the regular retail investors. But this means that most people who are bullish already own it - and it’s the first warning sign that the rally is probably near at least a short-term top. And once the talking heads on CNBC begin waffling about it, the caution flag comes out.

You see, once a stock rally is in the news and the retail buyers are in control, this is when the professional, short-term traders begin selling into an extremely high volume rally - just as the public is sure they’re riding a winner.

Shortly thereafter, the stock usually begins to struggle as the volume tapers off. Shares will back off or move sideways as the battle begins to determine the next trend. If the stock begins to violate any technical parameters, the technical traders begin selling. This is where fear kicks in…

Is Fear A Factor In Your Trading?

Once a stock begins dropping, the public starts to get nervous. As a correction unfolds, fear sets in and the retail investor selling intensifies. You can feel the angst of investors, with the amateurs usually the last to sell - often at, or close to, a low.

Once a stock has undergone a substantial decline, it’s very tough to overcome the “fear factor” - even by the professionals. Most of the players are bearish, and the media hates the stock. It’s mentally very tough to buy into this kind of weakness, but if the sentiment and technicals are set up right, adopting a contrarian strategy, and buying a stock near its low point, is quite a thrill. And it can set you up to maximize your profits.

Here’s how…

Develop A Contrarian Investing Strategy And Win

Developing a contrarian investing strategy isn’t as easy as it sounds. It’s an art, as well as a science. The “art” part of the equation is usually exhibited by the professional traders who have seen how tops and bottoms have evolved through their years of experience.

For the less experienced contrarian investor, however, I suggest waiting for some type of short-term technical breakdown before entering a trade. I suggest using an hourly chart and look for a short-term violation of a stock trendline… a break of previous support or resistance… a close below a 2% regression channel… or any other technical indicator that you find to be reliable.

As a guide, if you pay attention to the points below, you can overcome the overriding fear in a market, and begin to pick up the profitable art of contrarian investing:

  • Watch for extremely heavy volume, or a sharp volume spike after a sustained move.
  • Bullish or bearish sentiment on a stock appears to be heavily one-sided.
  • The mainstream media chimes in and agrees with the popular sentiment.
  • Investor complacency is widespread.
  • The stock is close to its long-term support or resistance level.

Being an optimist when everyone is selling or a pessimist when everyone is buying requires independent thinking and is one of the hardest things a trader can do, although history shows that opposing the crowd can be very profitable.

Good Trading,

Jim Stanton

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Today’s Smart Profits Cribsheet

  • One of the best ways to gauge investor sentiment is by looking at the CBOE Volatility Index (VIX). This measure has proven to be a reliable indication of whether the overall investment mood is fearful or complacent - and can be critical in determining your next move. Just before Christmas 2006, my colleague Mark Whistler wrote extensively about how to use the VIX - so if you missed it over the holidays, check it out in Smart Profits #381, The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options.
  • 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. Mt. Vernon Research’s own Quantitative Analyst, D.R. Barton, Jr., talks more about this type of indicator in Smart Profits #378, Sentiment Analysis: Incorporating Contrarian Investing in Your Trading & Financial Endeavors.

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