Contrary Indicators Tip Off Discerning Investors in Year 2000

2000 was a banner year for contrary indicators -- those actions, exhortations and commentary that got it exactly wrong. Savvy investors who learn to recognize them avoid buying in at the top, or dumping 'em at the bottom.

How they work is fairly simple. Consensus in the marketplace is actually rare; whenever everyone believes the same thing, it bears watching. It's indicative of an unusual set of circumstances. (If everyone truly believed the same thing, no one would take the other side of your trade).

When investors behave as a herd, it is usually because they are excited about something. Some strong emotion has 'em riled up. And, as we know, greed and fear are the most prevalent emotions in the market. Near the top, the greed crowd grows frenzied -- its enthusiastic blood lust takes hold for stocks at any price.

Near the bottom, the exact opposite occurs -- a fear-induced panic ensues over every equity -- regardless of price or value. "Get me out, I don't care about price," panicked shareholders scream. That's mob mentality at its worst -- fraught with emotion and, usually, exactly wrong.

It is not just the public that generates contrary indicators; many reliable indicators come from market pros and the financial press. Those of us who track these sorts of things have their favorites.

Here are my top 10:

1. American Association of Individual Investors' Bullish Sentiment Readings.

A classic contrary indicator, AAII is closely followed by technicians and market timers. This sentiment reading reflects the investing public's emotional mood. A rating of 30% is considered excessive.

From a high of 5132 on the Nasdaq to the year's low near 2300, the AAII reading was strongly bullish at more than 60%. Three of five investors described themselves as bullish, despite the overall downtrend and numerous sell signals. To a contrarian, these investors were in "denial" as the market sold off, refusing to admit that the bull was dead.

At the most recent bottom on Dec. 22, they finally threw in the towel: The number of investors calling themselves bullish dropped by half, to 31%. The self-described bears, on the other hand, rose to 51%. This coincided with the start of the most recent rally.

The cliche "it's always darkest before the dawn" describes human nature: We are lagging, not leading, indicators. That's why the AAII sentiment reading has historically been a contrarian's most reliable tell.

2. Time Magazine's Man of the Year: Amazon CEO Jeff Bezos

The magazine cover strikes again! Disparaged by many, understood by few, this indicator states simply that whenever the bull or bear market is broadcast by the cover of a mainstream -- not business -- publication cover story, that run is over.

In Bezos' case, the Time cover story marked the peak of the Internet bubble.

The next time the chief executive officer of an unprofitable, debt-ridden, online book catalog company is named Man of the Year, call stock loan to see if you can borrow shares. When Time bestowed that honorific on Bezos, Amazon's (AMZN Quote - Cramer on AMZN - Stock Picks) stock was near its high of $113. It closed 2000 as a teen-ager at under $16. That's an 86% decrease. That's the magazine cover indicator at its best.

Runner-up: Time Magazine: How to Survive the Slump

Time's cover story completes the cycle. It called the top last year with Bezos, and now (the week of Jan. 2), it nails the bottom perfectly. Are these guys great or what?

3. Intel and Microsoft added to the Dow Jones Industrial Average

Talk about chasing a stock: After two decades of spectacular growth, these two megacaps were finally added to the venerable Dow Jones Industrial Average. That belated entry not only called a top in both stocks, but also marked the beginning of the boxmakers' slide.

Here's a little heresy on my part: The selection of the Wintel duo reveals the Dow Jones editors to be merely fallible humans. The Dow Jones Industrial Average may be the best known of all the indices, but that doesn't make the editor's choices any shrewder. The Dow's wide following only makes the selections something of a self-fulfilling prophecy in terms of performance -- at least for a while.

OK, technically, this addition was announced in the fourth quarter of 1999. But it was so prophetic as to the performance of both stocks in 2000 that I felt compelled to include it here. The moral is that whenever Dow editors chase a couple of stocks 15,000% or so, we should note the occasion and label it a contrary indicator marking a top...

4. Dow 100,000: Fact or Fiction? Dow 36,000?

Who says you can't judge a book by its cover? These two were perfect contrary indicators.

Disclosure: I didn't read either of these works. It was enough to recognize the outrageously bullish sentiment as a reflection of the national mood. Their titles gave me all the information I needed.

Let me point out the mathematical idiocy of these pronouncements: I predict Dow 1 Million (split adjusted) by the year 3001. Think a bit about compounding, and suddenly these calls suddenly look a little less prophetic.

Contrast both of these tomes with the book, The Internet Bubble: Inside the Overvalued World of High-Tech Stocks--And What You Need to Know to Avoid the Coming Shakeout. This book went against the prevalent school of thought, and hence, it was not a contrary indicator.

5. Excessive OTC: BB Volume

There are times when it seems like the herd is buying anything that's not nailed down -- regardless of price or quality. By the time the frenzy works its way down to the least-warranted, lowest-value, nonreporting companies -- the bulletin board stocks -- it's all over but the crying.

In an ordinary market, most of us never go anywhere near this junk. So it's worth noting when these micro-minis are jumping up on huge volume. It means that money has run out of credible places to go. That's when it is time to start thinking about money market funds.

If any reader knows of a reliable way to track bulletin board volume in real time, please let me know...

What are Barry Ritholtz's next five most reliable contrary indicators? To find out, check out Part 2.