A Horse of a Different Color

By: Guy Lerner | Tue, Jun 8, 2004
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This past Saturday I was watching Smarty Jones go for the Triple Crown. The pre-race favorite, Smarty was a shoe in to win it all. Never before had so many bet so much on one horse, and when the race was over, never before had so many been so wrong! So much for America's horse!

The conventional wisdom on Smarty Jones was that he could not lose. I know nothing about horse racing (even though I live in thoroughbred country), but the contrarian in me wondered if it was possible that everybody was leaning the wrong way. I wasn't trying to be contrary for contrary sake, but I did realize that maybe the odds on the other horses were higher than they normally would have been since everyone thought that Smarty Jones was a sure winner. Thus I reasoned why bother going to the window to bet on Smarty Jones just to win 20 cents on the dollar when the other horses presented themselves with more attractive odds.

So what does all this have to do with the stock market? For me the similarities were clear. In the stock market as is often the case, we often see that when the crowd is extreme in its belief, the crowd is wrong. This is the time to be contrarian. The question for racing fans and for stock speculators is: how do you know when the crowd will be wrong?

I don't think you ever really know and we can safely say, "there is no such thing as a sure thing." But, I think you can identify emotional extremes when the "majority" of stock market participants are leaning the wrong way. That is, you can quantify when it might be best to be contrary to the prevailing whims of the herd.

But before we take that "sentimental" journey, a word or two about the fundamental back drop to this stock market. Fundamental schmundamentals- sometimes they don't mean a thing. Rates are going up (usually bad for stocks), but the Fed is going to move slowly and plus all this is factored in anyway. See what I mean? At times it is not the fundamentals but the psychology of the whole darn thing that seems to drive prices higher or lower.

So today's discussion will focus on that time when everyone is betting on Smarty; remember we cannot predict the outcome but we can only identify a time when everyone is unanimous in their beliefs thus putting the odds in our favor for substantial gains if a reversal were to occur.

Figure #1 is a weekly chart of the NASDAQ 100 (see next page). The indicator in the lower panel is a composite of several sentiment surveys that are looking at the opinions on the stock market of 4 different market participants. The studies under consideration are the Investors Intelligence (polling newsletter writers), American Association of Individual Investors (polling individual investors), Market Vane Bulls (polling investment advisors) and Put- Call ratio (quantifying behavior of option players). While there is nothing new regarding my use of this data, my methodology of how I look at the data requires a bit of an explanation. First all the data is smoothed over a 4 week period and each 4 week moving average is wrapped in adaptive bands that look for extremes in the indicator relative to values over the past year. Using the adaptive bands is useful in that most people would agree that there are no absolute extremes from era to era. Extremes are relative and using adaptive bands helps identify extremes based upon the past activity of the indicator and not on some pre-determined level. Each indicator is then given a score based upon its proximity to the upper and lower bands. The composite indicator then is the average of all four indicators.

Ok got it?

Returning to figure #1 we can see that our composite sentiment indicator is now registering a score of zero. The interpretation is that our 4 different sets of market participants are extremely bearish on the market. The ovals on the chart highlight other "bearish" times.

Figure #1/ NASDAQ 100/ Sentiment Indicator (weekly)

So now that we know what the playing field is like how can we turn this into a profitable system? For entries, the composite indicator had to be less than 0.2 and the entry was an upward break of a down sloping trend line; the exit strategy was a downward break of an up sloping trend line. (The entries and exits were programmed via the computer using my proprietary Price Structure Analysis.) The results are shown in Table #1.

Table #1
Parameter Value
Profit Factor 8.11
Select Profit Factor 8.11
% profitable 92%
# of trades 14
Average win :: lost .6
Stop Loss 12%
Trading Period 17.2 years
Time in Market 37%
Days in winning trade 125 days
Days in losing trade 95 days
Buy and Hold Return 715%
Rate of Return 710%
Annual Rate of Return 39%
RINA Index 164

This simple but effective trading system illustrates the 2 points we have heard many times: 1) buy low; and 2) "buy them when nobody wants them." The system has several flaws including only 14 trades in 17 years and a large 12% stop loss; it should be noted that 11 of the 14 trades had a draw down of less than 7% from the point of entry. Good things about this system are its high win rate and the fact that the select profit factor and profit factor are equal meaning that the system's gains are not due to unusually large winners. Also, the annual rate of return was 39% per annum.

So does it always pay to be Mr. Contrary? After all, we all have heard that "the trend is your friend" and "don't fight the trend." For the most part, I think it is easier to make money going with the trend, which means going with the herd, but there are times when you need to break with the crowd and go your own way. And now I believe is a time to break with the crowd.

That is The Technical Take!

The Technical Take

$ bearish sentiment presents opportune time

$ long QQQ and SPY

Thanks for reading and I hope you have found my analysis informative, insightful and profitable....

If you would like more information regarding my methodologies, please contact me at blueguyzee@yahoo.com.


Guy Lerner

Author: Guy Lerner

Guy M. Lerner

Disclaimer: Guy M. Lerner is the editor and founder of The Technical Take blog. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. Under no circumstances does the information in his columns represent a recommendation to buy or sell stocks. Lerner may on occasion hold positions in the securities mentioned in his columns and on the Web site; in all instances, all positions are fully disclosed at http://thetechnicaltakedotcom.blogspot.com/. However, their positions may change at anytime. For more information on any of the above, please review The Technical Take's full Terms of Use and Privacy Policy (link below). While Lerner cannot provide investment advice or recommendations, he invites you to send your comments to: guy@thetechnicaltake.com.

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