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Ashwin was worried. His track record as a good stock picker was taking a knock. Of late, the prices of stocks he bought invariably dipped, while those he sold headed north.
In fact-finding mode, Ashwin figured that he had been swaying along with extreme market sentiments, instead of being fearful when others are greedy and greedy when others are fearful. He had been buying shares at high valuations, and selling when they had already been battered. Digging deeper, Ashwin found he could have saved himself a lot of loss , had he paid attention to some well known contrarian indicators.
Contrarian indicators are based on the premise that the majority is often a collection of fools. Such indicators provide clues about mood extremities in markets and stocks - both about peaks when bullishness reaches its zenith, and bottoms when bearishness touches its nadir.
Like most overreactions, such mood extremities are often followed by reversals. Stocks which hit peaks start yielding to gravity, while those which hit rock bottom begin their ascent to saner levels. This is something astute investors are quick to catch on and cash in on. Here's an indicative list of contrarian indicators, which could help you avoid becoming part of the herd.
‘TIP'SY MARKET
Warning bells should ring when the world and its uncle starts talking stocks and doles out ‘tips'. A tips-driven market is usually tipply with exuberance. When the shoe-shine boy began giving stock buying tips before the Wall Street crash of 1929, smart investors took it as a strong sell signal.
People with little connection to or knowledge about investments taking bets on the market and even encouraging others to do so may be a good indicator of optimism reaching irrational levels.
Also, at times like these, it is common to be bombarded with unsolicited calls and messages urging you to ‘not miss the golden opportunity' to invest in ‘sure-shot multi-baggers'. Many such stocks belong to the penny stock category, which vanish into thin air when the party ends. Be smart and avoid those who are out to make a quick buck at your expense.
Similarly, when the market is in panic mode and everyone is blindly rushing towards the exit door causing prices to crash, it may just be a good time to make great value buys.
VOLUME VARIATION
A huge change in trading volumes could also be an indicator of the markets entering the zone of irrationality. Towards the final stages of bull market frenzies, volumes may touch stratospheric levels with all and sundry eager for a share of the pie. Also, during severe market downturns, there can be a huge spike in volumes in the stampede to rush out. This could be followed by a sharp dip in volumes when fear dominates and paralyses investor decision-making. Such wild volume gyrations could serve as good contrarian indicators.
FUND-RAISING FRENZY
It is no coincidence that a majority of initial public offers (IPOs) and new fund offers (NFOs) hit the market during exuberant market cycles. After all, ‘happy' market conditions provide the best chance for companies and fund houses, especially those with poor track records, to be successful in their fund-raising efforts. Such situations could, however, also be red-flags. When companies with questionable fundamentals manage to raise money from the public, merely on the strength of market sentiment, then it may not be long before that sentiment turns sour.
PUT CALL RATIO
In the market, optimism and pessimism are often contagious, and may reach extreme levels beyond justification. The Put Call ratio is often used to assess whether the line is crossed. The ratio indicates market sentiment about the likely movement of the market or stock.
Puts represent an option to sell, while calls represent an option to buy. If puts are more than calls, overall sentiment would be negative, and the put call ratio (number of traded put options divided by number of traded call options) would be more than one. On the other hand, when calls exceed puts, the market sentiment would be positive and the put call ratio would be less than 1. If pessimism far exceeds optimism, put call ratio would be quite high, and is considered a contrarian buy indicator. On the other hand, when optimism overwhelms pessimism, the put call ratio falls sharply, and is considered a contrarian sell indicator.
VOLATILITY INDEX (VIX)
The volatility index (VIX), also known as the ‘fear gauge', measures expected market volatility and is used as another contrarian indicator. It tends to shoot up when market sentiment is bearish, and dips when sentiment is bullish. A sharp rise in the VIX is interpreted as unjustified pessimism and used as a contrarian buy indicator. On the other hand, a steep fall is interpreted as market complacency about risk and used as a contrarian sell indicator.
MAGAZINE SPLASH
Fame or infamy may also be a good contrarian indicator. When a company gets splashed all over the media and on magazine covers, there is a good possibility that the news which led it there has already been factored in by the markets.
Companies depicted in glowing terms in the media have often had a forgettable post-fame run on the markets. Likewise, companies which receive incessant bad press often do better than expected on the markets. Smart money seems to bet that often, companies appear on magazine covers only at the fag end of their best or the worst. So, the next time you see a company lionised or demonised, make an objective assessment before deciding to jump on to the bandwagon, or taking the route less travelled
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