Contrarian Thinking vs Mass Psychology

It is, in fact, nothing short of a miracle that the modern methods of instruction have not entirely strangled the holy curiosity of inquiry. - Albert Einstein

Contrarian thinking is good to spot initial new trends but usually does not work to well after that and really does not pay off when it comes to predicting market tops. The philosophy involved behind the contrarian methodology is simple in fact too simple and hence can only work sometimes. The basis of this thinking is that one should always take a position that is opposite to that of the masses. Following this kind of thinking would have resulted in a total massacre during the 1990’s bull market; many so-called top-notch newsletter writers missed the entire tech bull of the 90’s. It is also another reason why so many bears are losing their shirts, pants and underwear right now because they don’t get one simple thing. The masses can be right at times though in the long run they are unable to hold onto these gains. Contrarian thinking only tells you when the sentiment has changed it’s unable to gauge the level of change. In simple terms a contrarian would be shorting the hell out of these markets because the mass media and most of the investors are bullish and they would be getting skinned alive. Investors using mass psychology would gauge the degree of Euphoria and to be honest it has not reached a boiling point yet though the levels are getting pretty high. It’s for this reason we have used major pullbacks to open new long positions for the last 3 years. Thus a trader using mass psychology would start to tread with caution slowly locking in some gains but keeping his eyes open for possible quick opportunities. The biggest moves always come towards the end because the chaps that got burned shorting the markets and the neutrals that lost their mind sitting on the sidelines suddenly jump in and attack the markets with a combination of rage, frustration and despair. All the above emotions are negative and hence so are their returns.

Mass psychology is slightly more complex, yet at the same time a relatively simple concept to understand and use. There are two components one is basically the analysis of certain statistical data; here one has to be willing to spend time analysing and even going out and sometimes gathering one’s own data. The second component is a sensory component (this takes time to develop however one can still perform pretty well without this component); here one starts to see a pattern emerge based on random analysis of data. In other words you don’t have to have a specific amount of data but just bits and pieces but you start to sense a pattern and this pattern combined with the statistical data above can truly reveal an awesome picture.

One way you can go about gathering data is to watch regular Financial shows not too many but just a few of them, the ones that are the best are the ones that take calls from the public. Not the crammer show you won’t learn anything there other then how to lose your voice. We are talking about shows where random questions are asked and not ones where a subset of the investors are calling in all pumped up thinking they are going to make a killing using their advanced after hours trading systems. Another way is to talk to your neighbours, co-workers, talk to the chap at the local pizzeria, the local diner, and your family and see what they are thinking. Sometimes one’s family can be the best indicator of what one should not do. One should not let such valuable data go to waste.

So what we have now in the markets is a battle between the masses and the contrarians; the mass psychologists as usual sit down and watch these battles from the distance waiting for the right moment to strike. Two of the main prerequisites to becoming an advanced student of mass psychology are Patience and discipline; without these two traits all the data in the world will be about as useful to you as it would be to giving a jackass a compass and asking it to plot a course. There is another small problem with being a contrarian today and that is dealing with fashion contrarians. Many people think its cool to be contrarian nowadays; they jump to a few contrarian sites, read a few pieces of interesting info (at least they believe its interesting) and then like empty cans start screaming on the top of their lungs. However we need to be thankful for these individuals because in the end they do serve a purpose they help produce more uneducated investors which in turn equates to more profit for the patience and educated investor. Imagine how much harder it would be to win in these markets if just everyone had 10% more common sense.

Okay fast forwarding we think that the masses will continue to win this battle for a bit longer for two reasons.

1) Once the masses jump on a trend momentum players come in; they don’t care about TA or mass psychology or anything else. They just chase the markets up when they are going up and then chase them downwards when they are correcting. For the most part they are like dogs trying to catch their own tails in that they lose far more then they win. 2) The second reason is that there are a lot of investors who completely abandoned the stock market a few years ago when it crashed and jumped into the real estate market. Now that real estate is slowing down they are starting to look for new places to put their money. So we could have a nice little explosive final move here.

Let's look at a chart we posted several weeks ago. This is a 6-year weekly chart of the Dow and we can clearly see that the Dow has been locked in a tight channel formation for slightly over a year now. At this point in time the Dow is testing the top of the channel formation attempting to build energy to blast past it and put in a new all time high. The firs target will be a test of the 11, 200 ranges after that we think the Dow will attempt to enter our first target ranges (11350-11430). If the momentum is strong here then we think there is a chance that it could trade past 11,600. Market update Feb 23, 2006

Okay we tested and surpassed the 11, 200 range and then we got very close to testing the 11350 range; today we traded as high as 11334. Usually when you break out of a channel the first time there is a sharp pull back and we think that this time will be no exception. There is a pretty good chance that the Dow will test the 11,000 ranges again before mounting another rally. The Dow Jones transports have put in a new all time high and so has the NYSE composite. The fact that the NYSE has put in an all-new high is pretty significant as it is a broad measure of what the markets are doing.

Conclusion

Just like it took forever for the housing market to top and start pulling back we are going to experience something similar in the markets. The topping process could take a while. Lets look at the housing sector as an example; only in the last 6 months or so have prices started to come down across the board. However there are still niche areas that continue to witness an increase in their real estate prices. When the equity markets enter into the severe corrective phase a few sectors will resist this down trend and diverge; at any given point there is always some sector that’s in a bull market.

Bulls, Bears or neutrals never win in the long run (bulls remain bullish for too long, bears remain bearish for too long and neutrals are just too scared to commit). Only the trader that is willing to take a risk but based on the long forgotten concepts of using trend analysis, mass psychology and one who has a firm understanding of the two most important concepts in trading “patience and discipline” is the one that wins.

If we value independence, if we are disturbed by the growing conformity of knowledge, of values, of attitudes, which our present system induces, then we may wish to set up conditions of learning which make for uniqueness, for self-direction, and for self-initiated learning. - Carl Rogers