Market’s Rally Spotlights Contrarian Strategy

Sometimes it pays to find out what most investment advisers are saying--and then do just the opposite.

This key tenet of so-called contrarian investing--which gained new followers during 1982-87, when investors used it to try to guess the end of the bull market--was spotlighted again this week when the Dow Jones industrial index posted a 74.68-point gain Tuesday, its sixth-largest advance ever.

Several market watchers--looking for possible signs of an end to the current bear market--attributed that surprising rally at least in part to unusually strong pessimism among professional investment advisers. One prominent survey of such sentiment showed nearly 70% of advisers in a bearish mood.

With so many supposed experts in a downbeat frame of mind, the market had to be near at least a temporary bottom, contrarians reasoned. Some even suggested the start of a new bull market.

“The market was oversold; there was lots of bearishness,” says Ralph Acampora, technical analyst at Kidder, Peabody & Co., adding that the high level of pessimism signaled at least the start of a long-awaited summer rally, although not necessarily a new bull market.

But while contrarian analysis has its moments, its tools are not foolproof and are easily prone to misjudgments, many stock watchers say. It only should be considered among several factors when judging the market, they say.

The key to contrarianism is figuring out the consensus of investors--crowd psychology, if you will--and then going against it. Here’s the reasoning: If an abnormally high percentage of experts are pessimistic, it could mean that investors who follow them--particularly those most prone to bailing out--have already unloaded many stocks. Thus, not much selling pressure is left, and stocks can’t go down much more.

In addition, the shares they unloaded may have been bought by stronger willed investors with positive market outlooks, who are much less likely to sell. (Conversely, when sentiment is abnormally bullish, it means that investors are fully invested in stocks and thus not much buying pressure remains.)

When pessimism is so great, “your downside risk is very small. A lot of stocks have already been sold,” says Michael L. Burke, editor of Investors Intelligence of New Rochelle, N.Y., arguably the most prominent newsletter tracking adviser sentiment.

Investors Intelligence’s recent high bearish readings were cited by some analysts as influencing Tuesday’s rally. The newsletter this week showed 53.7% of the 140 advisers surveyed as bearish long term, one of its highest bearish readings in six years. Another 14.6%, while bullish in the long run, were bearish for the short term. That meant that nearly 70% were bearish for at least the short term.

Normally, a 55% to 65% reading of long-term bears is a good indicator that a market bottom is near, Burke says. For example, in April, 1982, Investors Intelligence showed a 60.9% bearish reading. The Dow ultimately bottomed out in August of that year, starting the torrid five-year bull market that crashed last October.

Conversely, in late August last year, when the Dow peaked at just over the 2,700 level before the crash, Investors Intelligence showed a 60.8% bullish reading, with only 19.2% bearish.

“In all probability, a lot of stocks have seen their absolute lows,” Burke says of his current readings.

But do these readings indicate a new bull market?

Many experts say no, arguing that other sentiment readings don’t necessarily indicate a market turnaround. They also urge investors not to overemphasize adviser sentiment, for it can give false signals.

First, abnormally high adviser bearishness still might be several months ahead of an ultimate low. Burke, in fact, is not predicting an out-and-out end to the bear market, saying new lows for the Dow Jones industrial index might still be ahead. Under these conditions, “stock selection is very important,” he adds.

Second, those who track adviser sentiment are not necessarily producing the same readings.

R. Earl Hadady, editor of Bullish Consensus, a Pasadena newsletter that also monitors adviser sentiment, says his readings show a more neutral stance than Investors Intelligence. His survey--which places a higher weighting to the views of advisers with larger subscriber followings--says 52% of his advisers are bullish. That is far from the 30% level he says is needed to show a significant market bottom. (His survey only measures bullish sentiment; thus, low bullish readings indicate a market bottom.)

“We wouldn’t consider this week’s rally as a big turnaround,” Hadady says.

In addition, adviser sentiment can easily be misread, in part because it can shift rapidly, particularly in today’s volatile markets.

And just because a high percentage of advisers are bearish or bullish doesn’t necessarily mean a trend is about to reverse, says Mark J. Hulbert, editor of Hulbert Financial Digest, a Washington newsletter that tracks performance of investment newsletters. The trend could still be gaining momentum, he says.

For example, Hulbert says, many contrarian newsletter editors were out of the market during many parts of the 1982-87 bull market because their sentiment readings were highly bullish, Hulbert says.

“Obviously investor mood affects the market. But its utility as an indicator is way overblown. It has to be properly interpreted,” Hulbert says.

Contrarian analysis “is still valuable, but it’s more difficult to interpret now because more people are using it,” says Paul Macrae Montgomery, capital market analyst with the brokerage firm of Legg Mason Wood Walker in Newport News, Va. For example, he asks: “If all contrarians are bullish, is that bullish or bearish?”

Also, adviser sentiment is only one of several ways to measure investor psychology. Other measures must be considered as well, and they must be uniformly bearish for a true market bottom to be reached, says Stan Weinstein, editor of the Professional Tape Reader, a Hollywood, Fla., newsletter.

That is not yet the case, he says. One key sentiment indicator that is bearish is cash levels of mutual funds investing in stocks. More than 10% of fund assets are now in cash or “cash equivalents” such as Treasury bills, higher than the 7% level that often indicates that mutual fund managers are pessimistic about stocks.

But another highly watched sentiment indicator, the put-call ratio, is not overwhelmingly bearish, Weinstein says. It shows the relation of put options (bets that stocks will go down) versus call options (bets that stocks will go up). For a truly bearish reading (which to contrarians would be bullish), calls shouldn’t exceed puts by more than a 1.5 to 1 ratio, Weinstein says. But calls recently have exceeded puts by more than 2 to 1.

Another sentiment reading, the tone of newspaper stories about the market, also is not strongly bearish, Weinstein says. Uniformly downbeat newspaper stories often indicate a market bottom since such stories would merely reflect mass pessimism among analysts and investors, he says. But many stories still reflect a positive tone about the market, he says.

So while the indicators could allow for a summer rally that may have begun Tuesday, it’s still just a rally within a bear market, Weinstein says. “The bear market isn’t over yet,” he says.