Sep 20

Contrarian Investing: Why most people screw it up

By Jani Ziedins | Free CMU

Welcome to the new Cracked.Market University educational series. Look for new articles every Monday and Wednesday. 

Spend any time following the market and you will come across the term “contrarian investing”. For those that don’t already know, this investing strategy takes a position in the opposite direction as the larger crowd. If the crowd claims something is a sure-thing, the contrarian sells it. If the crowd is rushing for the exits before things get worse, the contrarian jumps in and buys the dip. That description is simple enough to understand, but less clear is why this counter-intuitive trading strategy works so well and how come the crowd gets it wrong so often.

The first thing to realize is the crowd’s ideas are not wrong. Wisdom of crowds is a very real and powerful phenomena that I will cover in another blog post. For the time being, trust me when I say the crowd is smarter and more insightful than any of us can ever hope to be. But where following the crowd’s ideas gets investors into trouble is these ideas are already priced-in. That means most of the profit from investing in these ideas has already been made. I will use the following basic supply and demand model to show you how this happens.

The first thing to understand is stock prices are set exclusively by active buyers and sellers. I will dig deeper into this topic in another blog post, but for the sake of this discussion, people who sit in a stock or stay on the sidelines don’t affect the price. Only traders actively trying to buy and sell the stock determine the current market price. The price they agree to is the exact balance point between supply (sellers) and demand (buyers) at that precise moment in time.

The other key concept in this illustration is people trade what they think. If an investor loves Apple and he believes the stock is going to double or triple, we can be fairly certain this investor is already fully invested in AAPL. It doesn’t matter if a trader uses intuition, fundamentals, or technicals, as soon as he is convinced a stock is a good buy and he has the money, he buys it.

But the thing to realize is no matter how much this investor believes in this stock, once he buys, he places his bet and from that point forward is simply a passenger on the market’s rollercoaster.

If this is early in the process and the investor’s point of view is unique, he can spread the word and encourage other investors to follow his lead. But as his view becomes more and more popular, it is harder to find new people who don’t already believe in the idea. At this point the crowd of believers is so large that new recruits are hard to find. Even though owners have never been more optimistic, serious problems arise when there is no new money left to buy the stock.

Remember, price is the exact point where supply and demand are balanced. If we cannot find new buyers willing to join this party, it doesn’t matter how enthusiastic the crowd is, demand shrivels up and is overwhelmed by supply. The crowd is still extremely excited about this stock’s future, but without new buyers to keep pushing the price higher, supply and demand forces punish the stock.

This is an example of a bubble forming and the subsequent climax top, but the exact same process happens in reverse during capitulation bottoms. “Sell now before things get worse”, but the scariest point is usually the bottom of the dip because that is where we run out of sellers. Once that happens, supply dries up and prices bounce. Headlines stop mattering when no one is left to sell the bad news.

While these are extreme examples of climax tops and capitulation bottoms, the same process happens to a lesser extent every day across every timeframe. It’s no secret prices move in waves and almost everyone acknowledges this on a cognitive level. Yet every time prices move too far one direction or the other, rather than acknowledge this is just a normal and healthy gyration, human emotions take over and we assume this small move is the beginning of the next big move.

We can call the previous section Part 1. This is most obvious example of contrarian investing because it goes against the market’s price trend. But just as important to the contrarian investor is Part 2, when he goes along with the market’s trend.

All too often people mistakenly think they are contrarian investors when all they are doing is arguing with the market. If a price is going up, they sell it. If the market is going down, they buy it. At this point many of you are scratching your head because that sounds exactly like what I described in Part 1. Isn’t it?

Nope, not even close. Don’t feel bad, this is an easy to mistake to make and it costs a lot of smart people a lot of money every day. Contrarian investing is not going against the price or the trend. Never forget price and trend have nothing to do with contrarian investing! The only thing that matters to the contrarian is what the crowd thinks.

More often than not the contrarian trade is actual follows the market trend and buys something that has gone “too far”. Or sells something that has gone “too low”.

I will use AMZN as an example. Two years ago the stock was “unbelievably expensive” at $400 and its valuation was widely viewed as “unsustainable”. Yet today AMZN is trading near $1,000! How did that happen? Quite simply,  the crowd didn’t believe in Amazon. Rather than have too many people buy the stock at $400, too few people were buying it and there was a lot of upside opportunity left in it.

Never forget contrarian investing is going against the crowd, not the price. Don’t make that costly mistake when you are tempted to short something that is “too high”, or buy something that is “too low”. More often than not the right trade is the exact opposite of the one you want to make. That’s because our primal instinct compels us to become a member of the crowd and believe what the crowd believes. This is a fascinating topic that I will save it for another post. Stay tuned!

I’m excited about this new series because my head is overflowing with ideas and insights that came from two-decades of trading experience. I hope you come back for the next post. 

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Sep 19

Stick with this Bull

By Jani Ziedins | End of Day Analysis

End of Day Analysis:

The S&P500 added to last week’s breakout and continues its steady ascent into record territory. A tenth-of-a-percent is definitely not setting the world on fire, but these slow and deliberate gains tell us there is strong support behind these prices.

Rather than take profits near prior resistance, most owners are confidently holding for higher prices. While conventional wisdom warns us about complacent markets, what it fails to mention is periods of complacency last far longer than anyone expects. Confident owners don’t sell dips and the resulting tight supply props up prices. That description fits this market to a tee and I don’t see a reason for that to change anytime soon.

Several weeks of bearish headlines failed to dent this market and Trump was at it again Tuesday, telling the UN he will “Totally Destroy” North Korea. But by market standards, this is already old news and it barely reacted to those provocative headlines. Clearly these headlines matter to geopolitics, but they no longer affect the market because anyone who fears these North Korean headlines sold weeks ago. These nervous sellers were replaced by confident dip buyers who demonstrated they are not afraid of these headlines. When no one is left to sell the bad news, it stops mattering.

A market that fails to go down on bad news creates a powerful buy signal. It means the path of least resistance is higher and prices will pop once the flow of bad news abates. That is exactly what happened last week when we surged to record highs. While it is easy to say this after it already happened, readers of this blog knew this rebound was coming several weeks ago.

Going against the crowd and buying when everyone else is running scared is hard to do, but that is the best way to make money in this business. Keep your cool by carefully analyzing the headlines and price-action. The thing to remember is trends continue countless times, but they reverse only once. Keep that in mind every time someone tries to convince you this time is different. Without a doubt they will eventually be right, but they will be wrong an awful lot before that happens.

As we saw today, the North Korean rhetoric no longer matters to the market and we can safely ignore it. Next item coming up is the Fed’s policy statement on Wednesday. Consensus is the Fed will start winding down its balance sheet. This is an anti-stimulus move, but the market is largely ready for it. Yellen and the Fed have done a great job telegraphing their moves to minimize disrupting financial markets. While we should expect a brief bout of volatility, it’s been years since a Fed decision affecting the market in a significant and lasting way. I don’t expect tomorrow to be any different.

If this market was fragile and vulnerable to a crash, it would have happened by now. Last month’s dip and consolidation refreshed the market and gave us a solid foundation to build on. That said, the market likes symmetry and last month’s small and short dip will lead to an equally unimpressive rebound. We’re already most of the way there and it will take something new to keep prices rising.

Luckily there are a lot of recent sellers and underweight money managers under pressure because they are missing this rebound. Soon the fear of a selloff is going to be replaced by fear of being left behind. Expect this chase for performance to fuel a strong rally into year-end.

As I said previously, if we were going to crash, it would have happened by now. Markets don’t move in straight lines and expect volatility to continue, but the path of least resistance is definitely higher. Stick with what has been working: buy-and-hold and jumping on each dip.

Jani

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Sep 14

North Korea still doesn’t matter

By Jani Ziedins | End of Day Analysis

End of Day Update:

On Thursday the S&P500 slipped modestly, but it is hard to call a 0.1% dip a material loss. This is the third close above 2,490 and continues the strength following Monday’s breakout. These record highs are a long way from the fear and uncertainty that dominated headlines over the last several weeks. As I’ve been saying for a while, a market that refuses to go down will eventually go up. And that is exactly what happened here.

It is constructive to see the market hold Monday’s breakout. Bears have been unable to break this bull market even through multiple waves of bearish headlines. This shows most owners are more inclined to hold for higher prices than take profits or succumb to fearful selling. The last several weeks of consolidation firmed up support and built a solid base for the market’s next up leg.

But just as things were starting to look good, North Korea launched another missile over Japan after Thursday’s close. Fortunately the stock market is reacting less and less to each successive provocation. In after-hours trade the S&P500 only dipped 0.2%. That’s because stock owners who fear this story sold weeks ago. These nervous owners were replaced by confident dip-buyers who demonstrated a willingness to hold these headlines. If there is no one left to sell the news, it stops mattering.

Even though this latest North Korean threat is unlikely to trigger an avalanche of selling, it is enough to keep buyers sitting on their hands. Their lack of buying could weigh on prices tomorrow. But just like every other dip over the last few weeks, any weakness is a dip-buying opportunity. If the previous North Korean provocations couldn’t break this market, there is no reason to think this episode will end any different. If we were going to crash, it would have happened by now.

Once we traverse this latest North Korean speed bump, expect the slow drift higher to continue. Confident owners don’t want to sell no matter what the headlines say and their conviction is keeping supply tight. Conventional wisdom warns us about complacent markets, but what it often forgets to mention is these periods of complacency last far longer than anyone expects.

Few things calm nerves like a rising market. Expect these steady gains to shift the focus from fear of a crash to being afraid of being left behind. Recent sellers and underweight money managers will start realizing the dip they predicted isn’t going to happen and they will be forced to start chasing prices higher. Last week’s seller will be next week’s buyer. And that’s how the slow grind higher will continue.

Keep doing what has been working and that is sticking with this bull market.

Jani

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Sep 12

Why bears got it wrong

By Jani Ziedins | End of Day Analysis

End of Day Update:

On Tuesday the S&P500 extended Monday’s breakout to record highs. While the gains were modest, traders were more inclined to buy these highs than take profits. But this is no surprise to regular readers of this blog. Last week I warned bulls to close their shorts proactively and take losses while they were small.

Quoting Thursday’s free blog post:

Anyone who is still short this market is probably only a little in the red. Rather than hope and pray for the selloff that isn’t happening, a smart trader admits defeat and takes his losses while they are small. This bearish trade has been given every opportunity to work, but this simply isn’t the right environment to be short. Be proactive and close a trade that isn’t working when the losses are small, rather than wait until the pain of losing money gets so strong it forces you out.

There is no magic to this. Basic market psychology and supply and demand told us the path of least resistance was still higher. In early August we tumbled when Trump and North Korea fell into a war of words that quickly escalated into North Korean missile and nuclear bomb tests. Then the Trump administration endured a rash of turnover in its senior ranks and at the same time exchanged barbs with senior Republican leaders. And finally two hurricanes did their best to pummel the Gulf Coast. Any one of those things would have crushed a vulnerable market. Put them all together and it creates a storm only the strongest market could endure. Yet that is exactly what we did.

The thing to remember is market crashes are breathtakingly fast and the only way to survive them is to sell first and ask questions later. But this latest selloff occurred in slow motion. In nearly a month of selling we only managed to dip 2% from all-time highs. That was after an endless string of negative headlines. Bears had their perfect storm, yet the market was still standing. That was the clearest warning possible that bears were on the wrong side.

As I’ve been writing for months, confident owners are keeping supply tight. While conventional wisdom tells us complacent markets are prone to collapse, what it forgets to mention is these periods of complacency last far longer than anyone expects. That’s because confident owners keep supply tight when they refuse to sell every headline and dip. If owners don’t sell the news, it stops mattering. That is exactly what was happened over the last month.

Since early August, nervous owners were bailing out of the market and selling to far more confident dip buyers. These new owners showed a willingness to own this uncertainty. In a bit of a self-fulfilling prophecy, those that confidently bought were willing to own the risk and uncertainty. Because they didn’t sell the fear, supply dried up and we bounced. News gets priced in once those that are afraid of it sell to new buyers who don’t fear it.

But that was then and this is now. What most readers want to know is what comes next. Plain and simple, expect more of the same. If we were going to breakdown, it would have happened by now. The path of least resistance is still higher. Nothing calms nerves like rising prices and this breakout to record highs is making the fears of the last several weeks fade from memory. Fear of the unknown is quickly being replaced by fear of being left behind. Big money managers are returning from summer vacation and they will start positioning their portfolios for year-end. Many of the underweight managers are coming to the realization that the dip they were waiting for isn’t going to happen. The pressure of being left behind will force them to chase prices higher into year-end.

This is a slow-moving market and I don’t expect us to launch higher, but expect the slow rate of gains to continue. A market that refuses to go down will eventually go up and that is what is happening here. Recent sellers will realize their mistake and fuel the next round of buying. I expect volatility to pick up this fall, but every dip is a buying opportunity. Stick with your buy-and-hold positions and keep adding when prices slip. This bull market will eventually break like every one that came before it, but we are not at that point yet. If you are out of the market don’t chase prices higher, but if you want to get in, be ready to jump on any dip.

Jani

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