This contrarian indicator suggests the market has further to rise

Before I get started – we’ve just put our 1,000th issue to bed! It’s out tomorrow! Subscribe now if you don’t already! First six issues completely free! And a free ebook as well!

OK. That’s my quota of exclamation marks used up for the next 1,000 issues.

This morning I want to look at contrarian indicators and one in particular that I’m a fan of.

To cut a long story short, it suggests that despite the rapid rally we’ve seen so far, and despite the horrible economic news, there’s no reason to expect another big collapse in the immediate future.

Let’s look at that in more detail.

The logic behind contrarian thinking

Firstly, what’s the logic behind contrarian thinking? After all, just because lots of people think something will happen doesn’t mean that they’re wrong (indeed it’s basically the reason that we use markets – “the wisdom of crowds”). Going against the crowd in a simplistic, knee-jerk manner is in many situations a stupid – or even life-threatening – thing to do. So why consider it in markets?

OK, first we have to think – what do markets actually do? Markets are forward looking. They don’t price in what’s happening today. They price in what they think is likely to happen tomorrow, or further into the future. This is why a company’s shares usually take a dive when they issue a profit warning. Because it’s an unexpected nasty surprise. Or it’s why they rise when they unexpectedly beat expectations – it’s a pleasant surprise. The point is: it’s news that the market hadn’t priced in already.

So you can look at the market as, at any given moment, being positioned for one specific future. If and when things change, the market will move accordingly, to price in a different future.

Usually the market isn’t at all bad at this. Again – that’s why we use markets. If markets were terrible at sending out price signals then it would be pointless to have them. They’d be no better or worse than having one guy in an office somewhere dictating how many tractor parts the factories needed to produce that year.

As it is (and despite the best efforts of central banks thus far) they are a lot better at allocating resources than the central planning option, and so we stick with them.

The thing is though, markets are made up of human beings. Human beings are fallible and the future is unknowable. So, while the market is pretty good at pricing the future, it’s not perfect. Being the sum of collective human endeavour (yes, even the algos, at least so far) it’s also very prone to extremes of greed and fear.

When a market hits those extremes, it tends to be pricing in extreme scenarios. Like a world where a small chunk of land in Japan is worth more than the entire state of California, for example (to cite one nice line from the Japan bubble of the 1980s).

So the potential benefit of contrarian thinking is this: it’s not that you, the individual, know what’s going to happen in the future any better than the rest of the market does. You’re not that smart. I’m not that smart. No one is.

It’s more that it’s useful for you to be aware of when the market is pricing in a future that is highly unlikely. Because if the market is betting too heavily on an unlikely outcome, then there will be a significant correction when enough “real world” evidence stacks up to make this obvious to everyone involved.

(If you’re interested in all this stuff by the way, I wrote a book about it called The Sceptical Investor – you can buy it on Amazon here.)

Fund managers are really rather gloomy

So this is why I like to look at various indicators that point to how market participants are feeling, and what the “common knowledge” of the day is.

Let me warn you now that a lot of this is “gut” feeling. It’s like the “cover story” indicator – whereby a magazine or newspaper cover has such an obviously bullish or bearish cover, that it’s clear that there’s too much euphoria or panic around.

But other indicators are a bit more scientific. Probably my favourite measure of sentiment is the monthly Bank of America global fund manager survey. This looks at where fund managers around the world claim to be putting their money.

If positioning gets extreme, then it often pays to do the opposite. (Again, this is not because you know better than the fund managers. It’s for the simple reason that if every fund manager in the world has bought into a stock, there’s no one left to buy – an extreme example, but that’s roughly how this works).

So how do fund managers feel right now?

Well, the answer is “pretty damn bearish”. According to the latest survey for May, one in ten fund managers expects a V-shaped recovery. Nearly 70% reckon this is a bear market rally.

They’ve got about 5.7% of their assets in cash, which is very high by historical standards (the ten-year average is 4.7% and, for perspective, cash balances were about 5.5% at the peak of 2008 financial crisis pessimism).

Another point of interest – apparently the managers also haven’t been this bearish on value stocks relative to growth stocks since December 2007 (which was roughly when value’s last brief period of dominance kicked off).

That suggests to me that, where they are in the market, they’re heavily invested in the “best” stocks – ones like Amazon, the stocks that you won’t get fired (by your clients or your boss) for owning.

Does any of this mean that the market is cheap? Not at all. Does it mean that there’s scope for it to go higher? Yes it does. In fact, the longer it goes on for, the more likely it is that these investors panic and try to pile in, looking for riskier assets with the potential to go higher and help them to catch up on all the potential gains they’ve already missed.

What does that mean for you? As always, you don’t need to worry. Just stick to your plan (and get one if you don’t have one). However, it is useful to know that despite the solid rise in markets since late March, there is still a lot of bearishness about. That implies that we’re nowhere near the point where we have to brace for another big collapse.

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