The editorial staff of one of the country's most prestigious newsletters has just taken me out back to the proverbial woodshed. And for a sound beating at that.
'D.R., are you sure about this analysis that the dollar is going up? Every other analyst that we've talked to says the dollar is going to crash. This is really going against the crowd.'
'But I thought this was a contrarian newsletter,' I protested.
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'A crashing dollar is contrarian,' shot back the reply.
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'Apparently not today,' I thought to myself.
The above discussion is largely fictionalized to help bring home a point. You see, 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.
Let's take a look at one of the most basic tools of sentiment analysis - consensus opinion - and how you can use it today to protect or build your own portfolio.
Dollar collapse: Sentiment Analysis
On December 5, the dollar made an 18-month low.
Dollar sentiment was (and still is) at ridiculously low levels. Every talking head and analyst in the land has been kicking the good old greenback square in the ribs.
In fact, The Economist, that venerable British weekly, had a picture on its cover showing George Washington from the U.S. dollar bill looking down with his mouth agape, accompanied by the headline: 'The falling dollar.'
So when I did my analysis of where the dollar is likely headed, two things stuck out:
1. Everybody and his brother thinks the dollar is going down.
2. We are less than 5% away from the all-time lows established in the trade-weighted dollar index.
Anytime we get sensational gloom-and-doom news magazine covers, together with overwhelming consensus opinion, I get excited about market turns.
Because history shows us that when everyone thinks a market can only go one way, it usually heads the other way - and in a hurry.
Dollar collapse: is history repeating itself?
Since the aforementioned discussion on the dollar, it has risen almost 2%. This has prompted headlines like: 'Euro Collapses In Corrective Selloff.'
The power of contrarian investing and trading shows off again.
Sentiment analysis is a fairly blunt tool when it comes to timing market turns (though it may have nailed a turn in the dollar pretty closely). However, it is one of the most powerful predictive tools available. If you'd like to learn more about contrarian investing and the basic precepts of this facet of sentiment analysis, please see the 'Tips and Tricks' section below.
Guidelines for contrarian investing
So how can you incorporate contrarian investing in your trading and investing activities? Here are some guidelines:
- Don't start selling out of your positions just because consensus opinions start to move to extremes and news weeklies start to run cover stories. BUT... these useful indicators should prompt you to make sure your stops are in the right place and that you take extra care in opening new positions.
- Remember that consensus opinion is generally a poor timing tool. Consensus can gel for quite some time before the smart money takes over. Use good technical and price analysis tools to sharpen your timing of market tops and bottoms. It's best to wait for the price to start moving in your favor, instead of trying
By D.R Barton Jnr, Quantitative Analyst, Mt. Vernon Research for the Smart Options Report, www.smartoptionsreport.com
