Contrarian Trading with Common Sense

I read an interview where a trading expert shares his views about trading on the contrarian side. I find it rather enriching and actually sometimes it can turn into common sense when you think it simply.

I was advocating investing during the past year (as you can see from all my posts) when P/E ratios were really low for the taking and globally, the bad stuff is coming to the rock bottom and turning tides soon.

With the STI touching 3,300 today and Dow Jones breaking 14,000 level; it shows a spectacular bull run is on the way. However, some pull-back is necessary. After the recent steep rise, a consolidation followed by a decline in STI is closing in especially when the May effect takes control once again...

Nevertheless, let's enjoy the article below...

How to Enjoy a Lifetime of Trading Success

The Daily Crux: You've mentioned in the past that to enjoy a lifetime of trading success, you've got to be able to spot "extremes" in the market… that you must become a "connoisseur of extremes." What do you mean by that? Brian Hunt: By saying you should become a "connoisseur of extremes," I'm saying you should always be searching for situations where a market is in a drastically different state than normal. By locating these extreme states – and then betting on conditions returning in the direction of normal – you can consistently make low-risk profits in any type of market. It's important to realize that extremes can occur in any market – from stocks to commodities to real estate to bonds to currencies. Extremes can be fundamental in nature… like how cheap or how expensive a stock market is. Another name for this is a "valuation" extreme. Extremes can also be price-action based… like how overbought or oversold a market is. That's a "technical" extreme. And extremes can show up in sentiment readings, like surveys that monitor investor pessimism and optimism. Crux: Let's cover valuation extremes… Hunt: Sure. A good example of a fundamental valuation extreme came in U.S. stocks in 1982. Back then, stocks became extremely cheap relative to their earnings power. For U.S. stocks, the normal price-to-earnings multiple over the past hundred years or so is 16. In 1982, the economy and the stock market had been doing so poorly for so long, people simply gave up on stocks. Since nobody wanted to own stocks, they became extremely cheap. The price-to-earnings multiple fell to around 8. It was one of the greatest times ever to buy U.S. stocks. The market rose 50% in just one year. It doubled by 1986. It rose more than 10-fold over the next 17 years. Fast-forward about two decades and you find the opposite extreme. In 1999, optimism toward stocks was so high that the market reached a price-to-earnings ratio of 33. This was a ridiculous, extreme level of overvaluation. Remember, the normal price-to-earnings ratio of the past 100 years is around 16. The extreme level of overvaluation made it a terrible time to buy stocks. The market crashed for several years after hitting that extreme. When it comes to fundamentals, you need to study an asset's historical valuation and find out what's normal for that asset. When an asset gets very cheap relative to its historical valuation, you need to consider buying. When an asset gets extremely expensive relative to its historical valuation, you want to consider avoiding it… or even betting on it falling. This goes for oil stocks, tech stocks, real estate, and lots of other assets. Crux: OK… so people need to buy stocks when they get extremely cheap relative to their historical norm, and avoid them when they get extremely expensive relative to their historical norm. How about extremes that are "technical" in nature? Hunt: Before we get into particulars, let's define the term to prevent confusion. Technical analysis is the study of price action and trading volume. Many people think technical analysis is all about predicting the market, but it's not. It simply comes down to using price and volume data to gauge market action… and to help guide decisions. That's it. There are dozens of technical indicators that measure a stock's oversold/overbought levels. One I've found useful is the "RSI," which stands for "relative strength index." The RSI is nothing magical or predictive. It's simply an objective way to gauge the overbought/oversold nature of a stock. My colleague Jeff Clark is amazing at finding short-term technical extremes in the market. He uses an indicator called the "bullish percent index" to identify overbought/oversold extremes in broad market sectors. I'm sure Jeff will tell you there's nothing magical or predictive about the bullish percent index. Again, it's simply an objective way to gauge price action. We are using these gauges to identify extremes in the market… then betting on the conditions being "relieved" in the other direction. When the pressure behind an extreme is released, the market tends to snap back like a rubber band stretched to its limit. There are literally hundreds of technical indicators and chart patterns people use. While I have a handful of things that I know work, what works for me or you or someone else isn't as important as knowing the overarching goal: That you're using this stuff to spot extremes and trade them. For example, I often trade short-term moves in blue-chip stocks, like Coke and McDonald's. These are elite businesses with tremendous competitive advantages and long histories of treating shareholders well. But like any business, even stable blue chips go through rough patches. If they report a weak quarter or have a product recall, or any other of a dozen solvable problems, the market tends to overreact and sell the shares. The stock price will reach a state we can term "oversold." This is a condition where the stock has reached an extreme level of poor short-term price action. It's around this time that I'll step in and trade the stock from the long side. World-class businesses have a way of rebounding from short-term setbacks. They tend to snap back from extremely oversold levels. Crux: OK, when it comes to technical analysis, we're looking for extreme conditions that when relieved, produce "snap back" moves. You mentioned extremes in sentiment. Let's cover that idea… Hunt: Let's also define this term to prevent confusion. The study of market sentiment comes down to gauging the amount of pessimism or optimism toward a given asset. You can gauge the sentiment for just about any kind of asset… be it stocks, commodities, real estate, or currencies. Gauging market sentiment is more an art than a science. There are lots of ways to gauge sentiment that cannot precisely be measured… and some that can. Whatever gauges you use, the goal is the same: to find extreme levels of pessimism or optimism. You want to find situations where the majority of market participants are extremely bullish or bearish… and then bet against them. You want to go against the crowd. When most folks can't stand the thought of owning a particular kind of investment, chances are good that it's cheap… and that it's due for at least a short-term rebound. On the other hand, when everyone loves an asset – like when everyone loved stocks in 1999 – chances are good that the asset is expensive and due for at least a short-term drop. A few informal sentiment gauges – the kind that can't be precisely measured – are magazine covers and cocktail party chatter. If a mainstream publication like Newsweek or Time has an asset on its cover, chances are good that the asset is far too popular, far too expensive, and due for at least a short-term drop. Magazine publishers have to write stories lots of people want to read. Plus, it's mostly journalists – not great investors – who write those stories. Mainstream magazines are just going to write about what's popular so they can sell lots of magazines. Back in 1999 and 2000, they always had stocks on their covers. It was a danger sign. In 2006, it was all about how to cash in on the real estate boom. That was a danger sign. The idea behind studying cocktail-party chatter is similar. It's another way to get a feel for what the general public thinks about a given investment. You can get a feel for this by talking to people at cocktail parties, family gatherings, holiday parties, and dinner parties. When lots of people are excited about a given asset and are buying as much as they can, it's a major warning sign. It's a sign the asset is too popular, too expensive, and due for a fall. On the other hand, when most folks can't stand the thought of owning a given asset, chances are good that it's a good buy. For example, back in 2003, I put a large portion of my net worth in gold. When I'd tell people that I owned a lot of gold, they'd look at me like I was crazy. You could say there was an extreme amount of disinterest in gold. Gold went on to rise many hundreds of percent. Crux: What are some sentiment indicators that can be measured precisely? Hunt: Money managers and investment newsletter writers are always being surveyed and monitored. Just like most regular investors, the supposed professional investors get swept up in crowd-following behavior. You want to bet against extremes here as well. Crux: It sounds like being a "connoisseur of extremes" is all about finding abnormal situations, and then betting on them becoming normal again. Hunt: Exactly. It's important to note that being a "connoisseur of extremes" – and trading them – is about getting a powerful force of nature to work in your favor. That force is called "reversion to the mean." "Reversion to the mean" is a broad term that is used to describe the tendency for things in extreme, or abnormal, states to return to more normal states. You see "reversion to the mean" all the time. You see it in academics, business, trading, and dozens of other areas. For example, winning an NFL Super Bowl requires an extreme set of circumstances. A football team has to have a great coach… a great set of players… and they have to play extremely well for an extended period of time. The team's elite players have to avoid injury. And they have to beat a series of excellent teams at the end of the season. It's really hard to get all the stars aligned and pull off a Super Bowl winning season. That's why Super Bowl winners tend not to win the championship the next year. They tend to "revert to the mean" and not win it. To go back to the example of trading extremely oversold blue-chip stocks, if a blue-chip stock like Coca-Cola is sold heavily day after day for several weeks, chances are good that its trading action will "revert to the mean" and cease being so extreme. Chances are good that it will stop falling and start rising. Crux: Understood. Any final thoughts? Hunt: One last thing I think is important to note is that an extreme in valuation is often accompanied by extreme technical and sentiment readings. That's why I believe studying and trading the market with "just" fundamentals or "just" technicals can be a limiting mindset. Consider what happened with offshore drilling stocks in mid-2010, just after the terrible Gulf of Mexico oil-well disaster. After the disaster, investors dumped shares of offshore drilling stocks. They completely overreacted. It was like people believed we'd never be drilling for oil again. Sentiment toward the sector was terrible. Even companies with little business exposure to the Gulf of Mexico fell more than 30%. This big decline left the whole sector in an extremely oversold state. It also made the stocks very cheap. Great drilling businesses were sold down to valuations of around five times earnings. After the selloff, you had a sector that was extremely unpopular, extremely cheap, and extremely oversold from a technical standpoint. So I went long offshore drilling stocks and made big returns in a short amount of time. The stocks enjoyed a sharp "snapback" rally. Again, this rally was preceded by "extreme" valuation, technical, and sentiment readings. Crux: That's why it pays to look for extremes of all types. Hunt: Yes, exactly. Crux: Thanks for your time. Hunt: My pleasure.