The ultimate contrarian signal?

When stocks are popular, evidence suggests that future returns are poor. But timing the market is highly risky.

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We're fans of contrarian thinking at MoneyWeek. Contrarianism, which is poorly defined beyond being about "betting against the crowd", can often seem like a rather nebulous concept, more art than science.

Yet at its heart, contrarianism is about the hard logic of supply and demand. Put simply, if you've reached a point where every investor is a buyer, then you'll run out of buyers (and vice versa). That sets the scene for a reaction often a big one in the opposite direction. The tricky part which is where poring over sentiment indicators comes in is figuring out when market positioning is so one-sided that betting for a reversal is a better idea than simply continuing to "buy and hold".

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That brings us to an interesting piece of research by Nick Maggiulli on his Of Dollars and Data blog (itself based on research from pseudonymous blogger Jesse Livermore on the Philosophical Economics site). Maggiulli took data from the American Association of Individual Investors. He found that when the average investor has a lot of their money in equities then returns for the next ten years are low, and when allocations are low, then future returns are high.

Following on from that, if you had invested in the S&P 500, then switched into five-year US government bonds when the average investor had more than 70% of their cash in equities, and switched back into equities, when allocations fell below 50%, then you'd have beaten the market handsomely during both the tech boom and bubble, and the 2008 financial crisis.

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You'd have sold stocks in September 1996 and bought back in October 2002; and you'd have sold stocks again in May 2006 then returned to them in November 2008. Using the system between 1987 (post-crash) and 2018 turned $1 into $43, versus $23 for buy and hold, says Maggiulli. What makes this interesting today is that the system generated its first "sell equities" signal since the financial crisis, in January this year.

To be very clear, Maggiulli does not recommend following the system: we don't know if the signal will work this time, and even if it does, sticking with it could be psychologically very hard. For example, if you had sold out in 1996, you had to wait for a painful four years before the crash, doubting yourself the whole time.

It's a good point, and we certainly wouldn't suggest going 100% to cash (and bear in mind that this is all based on US data). That said, given that interest rates are turning, this signal is just one more piece of evidence that we're a lot closer to the end of this particular bull market than many in the markets appreciate. Tread with care, and consider shifting some profits from your winners into cheaper, more defensive assets.

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