Contrarian investors who heeded their mantra of never trusting the masses had a sweet ride in 2003, switching from bear to bull last March when pessimism was rampant. How will they know when it's time to turn again? Here's where we would look for direction.
Investors Intelligence survey has been widely adopted by the investment community as a contrarian indicator since its inception in 1963. Investors Intelligence studies over 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 are waiting to buy at lower levels on a pullback," says Investors Intelligence editor John Gray. Last week's survey had 58.3% bulls, 19.4% bears and 22.3% in the correction camp. Investors Intelligence 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. Consider March 7, 2003, when the survey listed 39.8% bulls, 37.5% bears and 22.7% looking for a correction. As opposed to the Odd Lot Balance Index, which contrarians use to bet against the small investor (see below), the Investors Intelligence 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 Investors Intelligence 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 seasoned pro, the American Association of Individual Investors maintains a survey on its Web site .
Sentiment SurveysPublished every Wednesday morning, the
According to the AAII survey, 65.5% of individual investors were bullish, 17.2% were neutral and 17.2% were bearish in the week ending Dec. 24. The bull number was up and the bear number down slightly from the week prior, another worrisome sign for a contrarian. When the U.S. stock market was about to ignite in early March, the readings stood at 33.3% bullish, 39.4% bearish and 27.3% neutral.
CBOE Volatility IndexFor contrarian and lay-trader purposes, the Chicago Board of 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. RealMoney 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 an exceedingly complacent 17.41. Back in early March the VIX stood above 30 before spending the remainder of the year in free fall. VIX readings above 45 have marked major market bottoms and ensuing rallies in the past.
CBOE Put-to-Call RatioThe 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, of course, is bullish if you're a contrarian betting against sentiment. The 21-day moving average on the put-to-call ratio read 0.57 at last Friday's close. At the start of the rally back in the first week of March, the daily put-to-call ratio ranged from 0.75 to 0.93. "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."