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A critical analysis of the contrary approach (4/2005)

(27.04.2005)

Humphrey Neill is deemed one of the fathers of the contrary approach, he wrote the book "The art of contrary thinking" a half century ago. It's interesting that today almost every market forecaster explicitly or implicitly considers himself to be a contrary thinker, so the claim to "lean against the majority with this opinion" is quite common in so many market analyses, comments, and prognostications. However, this assessment is seldom based on a representative and objective analysis but too often on arbitrarily chosen arguments that fit one's bias, and sometimes even without any arguments. In this article I want  to scrutinize the current practice in this field, pointing out the major flaws.

 

Explaining the popularity of the approach

Although the contrary approach is in my observation only mediocre in terms of reliability and accuracy it has nevertheless gained an astonishing popularity in the financial community Why? In my opinion the main reason is not its supremacy but rather its ego-supporting role in an ego-centric and narcistic society. The ego always wants to be unique and right ("I am the only one who is right and all others are wrong") and can't stand to be just a bleating sheep in a herd of bleating sheep... A similar irrational individuality cult can be observed in the astrological community where 90-95% of the Western horoscopes are cast for persons notwithstanding in many cases other methods (like horary astrology) would be faster, easier, more reliable, and more accurate.

 

Limits of the approach

As always a method can't be really powerful if its limits are not kept in mind, and unfortunately that's rather the exception than the rule. A too easy-going attitude without paying attention to the details is one of the cardinal sins of all techniques and distinguishes the pros from hobby-analysts and adventurers.

The contrary approach partially indicates the future direction of the market but a precision in terms of price and time is very rare and restricted to a few indicators. Note that Neill considered the contrary way mainly as an a thinking style or an analytical tool and not a method to make predictions. While I don't agree on this point it's essential to remember that contrary analysis requires a clear crowd sentiment to work, and the contrary approach can do very little if the crowd is not one-sided enough.

Isolated indicators like the poll of the American Association of Individual Investors (AAII) or  Investor's Intelligence (II) can't cover more than a tiny faction of the whole. In today's information overflow environment it's very simple to find many arguments pro and con but the key is to arrive at a balanced holistic assessment. The ideal of the holistic philosophy is that the whole is more than just the sum of its parts ("1+1=3") yet studies have shown that the average man or woman can't even correctly add information factors ("1+1=1.5") let alone arrive at a real synthesis. From my point of view there are only 2 solutions to that dilemma: either a full modeling or the expansion of one's consciousness to make use of the full mental capabilities (e.g. through meditation).

The most serious immanent problem (as already partly recognized by Neill) is that contrary thinking with sentiment analysis being dominant works best at the start and end of trends and less in the middle (yet by definition the odds that a trend continues is larger than it changes). So how should one know whether the trend will be turning or not (logical vicious circle)?

Besides, you have to search for the necessary wariness with a magnifier, instead you frequently read that the crowd is always wrong but I really can't let such an unqualified statement pass, there are never 100% certainties for market forecasts, a fair statement is that the crowd has a tendency to be wrong (being wrong more often than not).

example: In February and March 2003 the financial media were to a large extent of the opinion that the start of the Iraq war would trigger a massive rally, backed with good examples from the past. That's why my appreciated colleague Carl Swenlin said in a radio-show (before the outbreak) that this definitely would be the best-advertised rally in his decades of market experience. And you remember what happened...

The first step in contrary analysis is to find out the dominant opinion that is then interpreted in the light of the market environment, especially prices (!). If a market has risen by 20-30% and soared to a new all-time high bullish sentiment is adequate and not (!!!) a reliable contrary indicator - which is frequently "overlooked". Also, price is often following (!) sentiment, especially on a short-term basis.

Example: In late May/ early June 2003 an extremely bullish sentiment was present in most indicators but in contrast to similar situations in the preceding 2-3 years it didn't lead to a downturn since the market was somewhere in the middle of the cyclic bull market 2002-5.

I also do believe that the importance of contrary thinking is diminishing as less and less trading decisions are made by (emotional) human beings, e.g. the share of NYSE program trading is rising higher and higher, up to 70%+. Instead, other factors are now calling the tune, above all liquidity as long no one stops Alan "Bubble" Greenspan.

 

False Application

Indicators can be either anecdotal or statistical, depending on the type of the observations (systematic or not) and on the number of the underlying cases.

Example anecdotal sentiment: In late February/ early March 2000 I suddenly received a abruptly increasing number of requests of market greenhorns that wanted to make a big buck in the stock markets. No wonder that the markets were almost at their all-time highs.

Principally both approaches are valid though in the common practice the anecdotal indicators entail losses for most contrarians because of the selective perception and shortcomings of the human information processing. One has to be neutral as far as possible which is very difficult. To be on the safe side one should therefore concentrate on the objective statistical indicators and use the anecdotal hints as an interesting admixture, not more (see also this article on the necessity of statistics).

Most active market participants read so many opinions every week that it's easy to say that, "the market will go up because analyst XY is bearish" (or vice versa). However, you really get into hot water if you first form an opinion and then pick an arbitrary argument to confirm your bias. Individual persons should only be used as contrary indicators if they have an excellent "failure record" and not just "on suspicion" as that's unfair and insulting.

It's often assumed across the board that bullish sentiment is always bearish (and vice versa) but this is by no means the case, there are a lot of sentiment indicators of confirming and not contrary nature. And others again do typically lead or lag prices by weeks or months which is rarely factored in.  Last but not least it's helpful to remember that without exception everyone has to serve as a contrary indicator now and then....

Models

So where can you learn good contrary analysis? For me the best contrarian theorists that know the limits of their discipline and are not tempted to make things simpler than they are, are without doubt Mark Hulbert and Bernie Schaeffer. Their articles are the best "cure" against the prevailing hipshot-analyses. I use the contrary approach as a mediocre auxiliary method that can't compete with the leaders (astrology and cyclesA cycle is a recurring event in the markets.) because of the lack of precision.