Even More Contrary Indicators

Last week, I discussed some of my favorite contrary indicators from 2000. That column engendered a tremendous amount of feedback from readers.

These responses fell neatly into three categories: Many of you were intrigued by the idea of contrary indicators, and wanted to learn more about them. A second group of you had your own indicators, which you were gracious enough to share. The third group thought the entire exercise little more than Monday morning quarterbacking -- an after-the-fact rationalization that's of no actual value to investors.

My next two columns will attempt to address these issues. I'll go over the many, many indicators that readers wrote in about, and discuss a few more of my own. We'll try to discern which suggestions are valid indicators and which are not. Finally, we'll see if we can develop a few guidelines for determining if something qualifies as a contrary indicator.

Let's start with a more detailed definition of what contrary indicators are, and how they work, since that raised so many questions.

Contrary indicators are events whose significance to the market is the opposite of what their most apparent interpretation suggests.

The definition is the easy part; let's look at the underlying reasons why they are useful.

Contrary indicators recognize two facts: that markets are cyclical, and that people tend to make decisions emotionally.

The cyclical nature of markets is a given that needs no discussion here. Let's focus instead on the emotional nature of decision-making.

People are naturally reactive -- they tend to respond to events that have already occurred, rather than anticipating future events. The "Fight or Flight" instinct is a reactive -- rather than proactive -- response. As a species, it is one of our hardwired, instinctual tendencies.

Why is this significant? If you believe -- as I do -- that the market forecasts about six months out, investing by emotionally reacting to recent events puts you way behind the curve. You are trading in anticipation of news, which the market has already factored in.

This explains why so many of us clamor to get in at the top of the cycle -- because that's where the buzz and energy level is so great that we get caught up in our own enthusiasm. It simply gets the better of us. After everyone's in, who else is left to buy 'em?

It's also the reason so many investors sell at the bottom. That's where the discomfort level becomes unbearable. We cannot stand to watch our stocks fall and fall and fall further still, so to alleviate the pain we finally cry uncle, we toss in the towel, we pull out of the market, we panic, we capitulate. Historically, when enough people do just that, there's too few nervous hands left to sell into the next rally. That's one of the ways a bottom is formed -- after all the weak holders are washed out, stocks have room to rally.

So it's the cyclical nature of the market, combined with our own rearward-looking, emotional tendencies that form the basis of contrary indicators.

How does this apply to investing in real life? Several of you skeptically asked, "Isn't this little more than Monday morning quarterbacking?" Aren't these after-the-fact explanations of what has already occurred?

The short answer is no. Too many strategists and technical analysts have successfully used these indicators -- discussing them publicly -- and not in retrospect. For example, on Dec. 24, Aaron Task noted that Don Hays had flipped bullish (from recently being strongly bearish), a change of view "spurred, first, by investor sentiment -- a contrarian indicator. The American Association of Individual Investors survey showed bullishness fell to 31% this week from 60%, while bearishness rose to 51%."

That's just one example; there are many others. Here's how my own trading was influenced by the indicators discussed previously. Indicators 1, 2(b), 6, 8, 9 and 10 led to a more bullish posture. Indicators 2, 4 and 6 led a shift toward bearishness, including putting on a number of short positions. Microsoft (MSFT Quote - Cramer on MSFT - Stock Picks) being added to the Dow (No. 3) led to its sale; the Merrill downgrade of Cisco (CSCO Quote - Cramer on CSCO - Stock Picks) (No. 1) contributed to its purchase. Indicators 5 and 7 were not acted upon.

Let's review five more indicators to see how one can use them in actual trading or investing.

11. AOL's Purchase of Time Warner (Fall 1999)

The first Internet company to cash out of the Internet was a huge warning sign. The purchase of a slow-growing, clumsily managed Old Economy media behemoth let you in on AOL's (AOL Quote - Cramer on AOL - Stock Picks) thinking. "Let's take our monopoly money and buy a ton of cash flow and hard assets," Steve Case must have thought.

Apparently, AOL considered itself less an Internet company and more a media company. Nothing wrong with that, except for the huge Internet premium AOL was trading at. Hey, it's fine if you want to be a media company -- just not at 200 times trailing earnings.

I remember being very surprised at all the very positive feedback on the merger, because I just hated the deal. Many commentators praised it.

Action taken: I totally liquidated our entire AOL position that day, and exhorted all the salespeople in my firm to do the same (people screamed over that). However, other Internet stocks were not sold -- despite this indicator. Ultimately, they went much lower.

12. Put/Call Ratio

"Option traders never die, they just expire worthless."

That old joke summarizes why retail option buyers are good contrary indicators: More than 80% of all options expire worthless. Historically, option purchasers are among the worst investors in the market.

When they get too bearish, they purchase puts . When put buyers dramatically outweigh call buyers, it's a very good sign of a bottom.

This indicator very often coincides with the American Association of Individual Investors' sentiment reading. Because it's more than just a survey -- actual money is being spent it's a good confirming signal when combined with AAII.

Action taken: Confirmed the shift toward bullishness on Dec. 20.

13. CNBC Call-in Factor

The modern version of the Shoe Shine Boy Indicator, although more of a stock-specific tell than a general market indicator.

Listen to CNBC during the viewer call-in segments. If you pay attention, you'll hear viewers ask questions about the same stocks, over and over.

At the end of 1999, you couldn't have helped but notice the inordinate amount of viewer questions about Qualcomm (QCOM Quote - Cramer on QCOM - Stock Picks) -- after the 480% run-up last year. To me, this is a sign to unwind the position. Even after its recent move off the bottom spike, Qualcomm is still off 65% from that time.

Recent questions? I hear a lot of viewer queries about General Electric (GE Quote - Cramer on GE - Stock Picks), EMC (EMC Quote - Cramer on EMC - Stock Picks) and Sun Microsystems (SUNW Quote - Cramer on SUNW - Stock Picks).

Action taken: Qualcomm was sold the first week of 2000 (a very good sell). Sun was shorted for technical reasons as it approached $100, resulting in three losing trades -- even working with tight stops -- before making up most (but not all) of the losses when it finally broke down.

14. Excessive Snapback Rallies

Days like Dec. 22 and Dec. 26, and more recently, Jan. 3, show that the bear still hasn't wrung the excesses out of the previous bull market.

When stocks like Ciena (CIEN Quote - Cramer on CIEN - Stock Picks), QLogic (QLGC Quote - Cramer on QLGC - Stock Picks), Sanmina (SANM Quote - Cramer on SANM - Stock Picks) and Juniper (JNPR Quote - Cramer on JNPR - Stock Picks) gain 20%, 30%, even 40% in a day, that suggests the selloff is not finished. There's a lot of speculative cash in the market, and until it's scared out (or gone), there's still excess that needs to be wrung out. For a good look at that, see Jim Cramer's recent column.

Whenever the Nasdaq has a "Top 10" percentage-gain day, that overenthusiasm is a sign that money is rushing back into the market in a panic. There is a fear of missing the next run, so everyone piles in. Todd Harrison has been advising you to take money off the table as the frenzy wears on. If you keep current with his Trading Diary, you'll see him scale out of longs into most rallies.

Action taken: The day of the interest-rate cut, took profits in Sanmina, Manugistics (MANU Quote - Cramer on MANU - Stock Picks), Micromuse (MUSE Quote - Cramer on MUSE - Stock Picks)QLogic and Mercury Interactive (MERQ Quote - Cramer on MERQ - Stock Picks). Profits were left on the table (pigboy!) in Qualcomm.

15. The Rise of the VC

As recently as April, venture capitalists were gracing magazine covers: Upside, Red Herring, Business Week, Forbes. Where had these formerly obscure investors been up until now? The success of Yahoo! (YHOO Quote - Cramer on YHOO - Stock Picks), eBay (EBAY Quote - Cramer on EBAY - Stock Picks) and Amazon (AMZN Quote - Cramer on AMZN - Stock Picks) catapulted these private investors into the public consciousness.

What's overlooked by most VC "fans" is that a good venture capitalist has a success rate of 1 in 10. That's a lot of losers before you hit paydirt. It's the Dave Kingman theory of private investments: a ton of strikeouts before the next towering home run. Before you uncover a Yahoo! or eBay, you make a lot of futile investments.

When guys who hope for one winner out of 10 become media stars, perhaps it's time to start lightening up.

Action taken: None. I completely missed trading on this one as it happened ...

Although this was a visible red flag, at most, it resulted in trepidation.

I hope this discussion clears up some questions you raised. There were many, many reader suggestions -- and with any luck, we'll get to go over them next time.