Editor's Note: Ask TheStreet is designed to answer questions about the market, strategies and investment methods. Please email us to ask a question, but keep in mind that we cannot offer specific investment advice.
What are some of the indicators that contrarians watch in order to know when the market will change direction? Thanks, J.W.
: Contrarian investors heed the mantra of never trusting the masses. They switch from bear to bull when pessimism is rampant and from bull to bear when everyone else sees not a cloud in the sky.
But how do they know when it's time to turn in the other direction?
Published every Wednesday morning, the
survey has been widely adopted by the investment community as a contrarian indicator since its inception in 1963.
studies more than 100 independent market newsletters and assesses each author's current stance on the market: bullish, bearish or correction. Investors looking for a correction are defined as being still optimistic on the markets but waiting to buy at lower levels.
The survey for the week ended April 5 consisted of 49.5% bulls, 27.8% bears and 22.7% in the correction camp.
considers the norm to be 45% bulls, 35% bears and 20% correction. But for contrarians -- who trade in the opposite direction of sentiment on grounds that general opinion in the market is usually wrong -- this steadily increasing bullish sentiment flashes a sell.
survey provides contrarians with a litmus of professional opinion, which over the years has shown itself just as susceptible to unproductive market emotion. As the
Web site points out, "Advisers are only wrong when you get too many of them to start thinking the same thing."
For contrarians seeking to track the sentiment of the individual investor rather than the pros, the American Association of Individual Investors maintains a survey on its Web site.
According to the AAII survey, 47.7% of individual investors were bullish, 29.1% were neutral and 23.3% were bearish in the week ending April 5. The bull number was up and the bear number down from the prior week, another worrisome sign for a contrarian.
CBOE Volatility Index
For contrarian and lay-trader purposes, the Chicago Board Options Exchange Volatility Index, or VIX, is most usefully referred to as the market's "fear gauge."
Technically speaking, however, the VIX is a measure of the level of implied price volatility of the S&P 100.
options guru Steve Smith explains the predictive nature of the VIX: "The underlying theory is that, at any given moment in time, the majority opinion is wrong. A rising stock market is viewed as less risky than a declining stock market. The higher the perceived risk is in stocks, the greater the demand for protective options, driving up prices and sending implied volatility higher. Hence, if everyone is in a panic, selling stocks and buying puts, the bottom might be at hand."
Smith notes that as a contrary indicator, the VIX is more reliable for defining market bottoms, expressed in extreme "fear," or high volatility, than for flagging tops based on "complacency," or low volatility.
The VIX currently stands at a somewhat complacent 12.6, although it has jumped to its highest level in a month. VIX readings above 45 have marked major market bottoms and ensuing rallies in the past.
CBOE Put-to-Call Ratio
The name of this indicator refers to the two main options classes, those that become valuable when the underlying stocks fall (puts) and rise (calls). The put-to-call ratio is simply the volume of all puts divided by the volume of all calls that trade on a particular day. Like the VIX, the put-to-call ratio runs in direct proportion to investors' nerves: The higher the number, the shakier their knees.
A reading over 1.0 indicates bearishness in the market, because a high level of put-buying indicates a rising level of fear. That bearishness, of course, is bullish if you're a contrarian betting against sentiment.
The 21-day moving average on the put-to-call ratio read 0.59 as of last Monday's close.
"Typically, traders like to see the put/call hit 1.5 or higher to get an oversold signal," says Smith. "But on a big down day, such as a market crash, it can hit extreme readings of 4 or greater. On the other hand, a reading of 0.50 or below indicates a high level of bullishness. So contrarians might think the market top is at hand and start selling."
Mutual Fund Inflows
Mutual funds are the largest ships on the financial sea, and contrarians say it pays to watch investor dollars flow in and out of them.
Arcata, Calif.-based AMG Data Services provides information on mutual fund money flow and holdings data every Thursday at 7 p.m. EDT. In order to provide this data, AMG collects and verifies data from more than 500 sources on 16,900 open-end mutual funds with total assets of about $8.2 trillion. AMG updates mutual fund holdings reports as they are filed with the
Securities and Exchange Commission
According to AMG, U.S. investors shoveled $1.2 billion into equity mutual funds for the period ending April 5. For contrarians looking for a trend, the flows were smaller than the $1.8 billion that the stock mutual funds took in during the prior week.