An Introduction to Contrarian Investing

Good morning! Today Troy continues about the investing for beginners series. You can check the previous posts about What are stocks and how to value them, How does Currency Trading Work, How are Currencies Traded, Investing in Commodities, What Fundamentals Affect Commodity Prices, What are ETF’s, What are Options, How are Options’ Prices Structured, Investing for Beginners Part 2 – Different Investment Strategies, When does Buy and Hold not Work, An Unconventional Approach to Buy and Hold, An Unconventional Approach to Buy and Hold Part 2, How the Investment Advisor Game is Played, An Introduction Into “Secular Investing”, Don’t Short When it Comes to Secular Investing, An Introduction into Trend Following, An Introduction into Technical Indicators, When does Trend Following Not Work, Risk Management for Trend Followers, Why Trend Following Isn’t that Useful Today

 

In the last post we just concluded our Trend Following series. Now, we’re going to cover a new investment strategy that has worked exceptionally well across various markets (stocks, commodities, currencies) since the 2008 market crash. This strategy is known as Contrarian Investing. Contrarian Investing is exactly what it sounds like – if everyone else is selling and the market crashes, you should buy into the market. If everyone else is buying and the market spikes, you should sell the market. Contrarian investing is based on a simple tenet: the crowd (when it moves in one distinct direction) is always wrong.

Obviously, this belief is not 100% true. What makes Contrarian Investing truly successful is that this investment strategy rests on a simple fact of the universe: mean reversion. When things go to one extreme, they will reverse towards the mean and go the other way. This also aligns itself with the concept of cycles. The whole universe travels in cycles. If the economy goes to hell (deviates from the mean), sooner or later this bad cycle will end and the economy will rise (mean reversion).

Similarly, when the market moves extremely quickly in one direction (e.g. a sharp sell off or a spike in the market), contrarian investing states that the market will rebound to the other direction.

When to Buy and When to Sell

That being said, when everyone else is buying, contrarian investing says that you should sell. When everyone else is selling, contrarian investing says that you should buy.

However, the critical question here is: how do you define “everyone else is buying / selling?” How do you quantify the strenght of a market sell off or a market strength? After all, only when you quantify something can you make objective, unbiased investment decisions. Extremes are known as Oversold and Overbought. When the market is Oversold (very intense market selloff), it’s time to buy. When the market is Overbought (very intense spike), it’s time to sell. To quantify Oversold and Overbought, we have 3 techniques.

Oscillator Technical Indicators

Previously we have already discussed the definition of technical indicators. There is a specific type of technical indicators for contrarian investing called oscillators. Oscillators oscillate (waiver) around a mean line (average). When an oscillator reaches an extreme, a BUY/SELL signal is generated. When the Oscillator rises above a pre-determined number (e.g. 80), the market is considered to be Overbought. Thus, it’s time to sell. When the Oscillator falls below a pre-determined number (e.g. 20), the market is considered t obe Oversold. Thus, it’s time to buy. There are many types of Oscillators, but they all generate similar signals at similar times. Below is an example of an oscillator:

The above picture shows RSI (Relative Strenght Index) below the market price. Like all technical indicators, Oscillators such as RSI only use the market’s close price. In the above case, the predetermined “Overbought” level was 70 and the predetermined “Oversold” level was 30. What your predetermined level will be is up to your discretion.

Using Extreme Time

As the saying goes (which is a pretty big cliche), “history repeats itself”. Contrarian investors and traders use time as a measurement for “how extreme is the current sell off / spike in the market?” If the current sell off / spike extends beyond any historical precedent, then this is a really EXTREME situation, and the market should reverse to its mean (go the other way) any moment now. Here’s an example.

Let’s say that in the past 13 years, the U.S. stock market index S&P500 has never fallen for 10 days in a row. That right there is a historical fact. If the market right now has fallen for 9 days in a row already, what are the odds that the market will spike? Considering that the market has never fallen more than 10 days, the odds of the market spiking is insanely high!.

Using Extreme Magnitude

Like using Extreme Time, using Extreme Magnitude also depends on history. If the current sell off / spike extends beyond historical precedent in terms of magnitude (what % has the market fallen/risen), then the odds of a market turn around are high. Here’s an example.

Let’s say that in history, no 1 month decline has gone beyond 10%. If the current 1 month decline has been 9%, what are the odds that the market will rally? Pretty high!