Pros and Cons of Contrarian Trading

07/18/2011 11:21 am EST

Focus: STRATEGIES

Trading against the prevailing sentiment in the markets is a viable strategy, but history shows that the contrarian approach has flaws and failures as well, making it ill-advised to trade exclusively.

The basis for contrarian trading is entirely sound: When everyone is buying like mad, prices are too high, so it is in fact best to sell at that point, and vice versa. There is a huge amount of literature on the dangers of going with the herd, and why the right time to buy is when there is "blood in the streets" and so on. However, like most allegedly sure-fire methods in the investment industry, contrarian trading has its flaws too.

The Essence of Contrarian Trading

The underlying idea is that the majority of market participants are generally wrong. The "masses" get carried away in booms and then panic at the first sign of trouble. As a result, they buy and sell at the worst possible times. The appealing logic is therefore that by simply doing the opposite of the masses, one can buy and sell at the right time.

The Methodology

According to German expert Uwe Lang (2009), enthusiastic contrarians regularly note what most market letters recommend. The stronger and more frequent the recommendations to buy, the more likely the contrarians are to sell, and vice versa.

The underlying logic is that market letters reflect prevailing and dominant market sentiment, which is already factored into current prices. So the best thing to do is the opposite of what the letters recommend.

The Flaws and Problems

Uwe Lang points out that in the 1980’s, this approach was popular and people really believed in it. In the meantime, however, it is known that consistent success on this basis is unlikely.

A fundamental problem is that if all market letters use this approach, they would actually have to do the opposite of what they themselves had recommended. This would lead to a vicious circle of chaos and confusion.

Furthermore, such a situation is in fact a classic fallacy of composition, meaning in this case that if one market letter is contrarian, that will work, but if most or all are contrarian, the process collapses. And in very real terms, how does one know when the fallacy starts to work, and how does one ever know how many brokers are playing this contrarian game?

NEXT: When and Where Contrarian Logic Failed

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When and Why Contrarian Logic Failed

For at least ten years, says Lang, "mass sentiment" has no longer delivered any reliable signals. For example, on August 14, 1998, when the biggest losses from the Asian/Russian crisis were about to occur, very few German market letters were optimistic. The dominant pessimism would have suggested it was a great time to buy. But in fact, there was a downswing in the offering.

The same thing prevailed in March 2000 when the market letters and mass sentiment were again very negative. The associated contrarian hopes of a market recovery were dashed, however, when the real bears out there squeezed the bulls very decisively out of the financial arena.

To make things even more complicated, Lang doubts that the market letters and market sentiment were really so pessimistic in March 2000. And this is a crucial point. How does one determine whether a market letter is actually pessimistic or optimistic? Most such letters are wary of making blanket statements and tend to balance pros at least partly with cons, or the other way around.

In mid-2007, the market letters proclaimed that stock markets could not fall further, precisely because too many investors were nervous and banking on the bears. In reality, however, a stock market boom always ends in a phase of euphoria, and that was lacking in 2007. So, again, the market sentiment was misleading.

At the end of 2007, the process repeated, with considerable pessimism prevailing in August. According to the contrarian view, therefore, prices should have risen, but the highs of July were not achieved again by the end of the year. In 2008, the financial crisis struck and chaos ensued, so there was no particularly useful message for the contrarians there.

The Implications

The existence of excessively euphoric markets (which are best avoided) and deep despair (which is a great time to buy) is not in question. But these tend to be exceptional situations in which contrarian approaches really do work well. On the other hand, the more routine cyclical ups and downs are not reliably reflected in market sentiment as expressed in market letters.

Market sentiment generally still provides useful input to investment decisions, but it is not a panacea that leads to the proverbial pot of gold. The fundamental lesson to be learned, says Uwe Lang, is that no "psycho instrument" is a really reliable stock market indicator.

Market psychology remains an important element in managing investments. But trying to measure the psychology on an ongoing basis and using it in isolation to make fundamental trend predictions is a fool's paradise.

The famous "state of the market" does indeed exist, and one can determine it with reasonable accuracy, but not with mass psychology alone. (Knowing what the market is thinking is the best way to determine what it will do next.)

In Conclusion

Despite the flaws, a degree of contrarianism is important. Situations where markets are at all-time highs are very risky and so too are the converse. Buying into euphoric markets is truly ill-advised, and so too is selling out in situations of panic when prices are plummeting.

However, particularly at in-between times, mass psychology is not a terribly good indicator of where stock markets are heading. Excessive reliance on the approach is therefore dangerous. One is going too far in regularly quantifying mass sentiment as an exclusive basis for investment and trading strategies.

By Brian Bloch of Brian-Bloch.com

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