Money Market

Is the crowd wrong? It isn’t... not always

13 December, 2013 | Posted By: Financial Mirror

Is the crowd wrong? It isn’t... not always

By Andreas Tserkezos
Candidate Certified Financial Technician (CFTe)
Technical Analysis & Research Department – YESFX LTD

Regarding Humphrey Neil, the crowd is correct many times. Turning points are what create problems to the majority, and the crowd comes along with wrong thoughts.
The why is simple. Based on Dow’s Theory, the trend has three phases. First, the accumulation phase, prevail fear among the crowd with some buys, called ‘smart money’. At that point the crowd that should buy are pessimistic. In the middle of the graph there is public participation and the feeling exists is enthusiasm since optimism is built up when the market prices rising. Thus, at the top of the graph, (market peak) there is overoptimism and greed while the ‘smart money’ sells and here, at the end of the cycle, the market will possibly decline. Too late for the majority to sell since it is over optimistic and greedy at that point. The points that the crowd was wrong were exactly the turning points.

Is it so simple to be a contrarian?
The answer is no. It is not easy to say “everyone else is bearish, therefore, I am bullish’’.
As a contrarian, you have to understand the crowd psychology and to determine why sometimes they act irrationally because a crowd is subject to instinct in a manner that independently they would never do. If you were alone, you would never throw a stone at someone else. But if you are in a football field surrounded by a crowd supporting your team the scene is different and the possibility to do it is higher. The imitation of the minority would be a reason that a crowd may act irrationally. What if Warren Buffet stated publicly “I believe that apple’s share will goes up”? The majority would buy the specific share, regardless the reason and the time. If an individual is a member of a crowd, the most common is to follow the mob unintentionally, blindly and emotionally. When political parties arrange a gathering, the followers are there without even knowing the reason; it’s just the emotion.

Is it so easy to be a contrarian?
Again the answer is no. A trader has to understand the difficulties to be a contrarian in order to bypass those difficulties and be against the wave. It is in human nature to be in agreement with people around us because of our need to conform.
What would happen if an analyst before the economic crisis (where markets were at their top) stated that a recession is looming. The analyst would be an enemy to all. People who hold a position in the market do not have all the answers; the only thing they have is a position. Believe in yourselves and not those who hold positions or the ‘experts’. They all have their own interest, even you. In addition, understand the sense of comfort by extrapolating the recent past. A specific trend is more likely to continue and you will feel more comfortable to believe that the trend will continue rather than to reverse. As a contrarian you have to understand these difficulties, treat them accordingly, bypass them and act objectively.
Understing the reasons and the difficulties to be a contrarian, it is interesting to see the three-step process in order to form a contrary opinion.
Firstly, you have to figure out what the crowd thinks regarding the market or an individual stock. A crowd has wrong thoughts during the turning points, therefore they should be at an extreme level in order for your contrarian opinion to make sense. Just start asking traders about their beliefs regarding the future of the market. When is clear that a general consensus is forming, and that consensus is approaching a ‘dogma’ then you have to move on to the second step... start thinking in reverse.
You know what the majority thinks, so try to come up with justifiable reasons why the crowd may be wrong. As you hear the majority of opinions, remove yourselves from the crowd, isolated yourself and think why the crowd’s opinion may not be correct. Moving on to the third step we have to identify when the crowd reaches an extreme.
It would be great at this point if you used the sentiment indicators in order to identify whether the crowd is either extremely greedy or pessimistic. A helpful indicator is the cash/asset ratio for the mutual funds. It is the amount of cash held by the mutual funds divided by the total assets of a fund’s portfolio. Since mutual funds tend to liquidate their positions first, be aware when this indicator will increase. If so, it means that mutual funds liquidate their position and the turning point is in front of us. Long term oscillators are a good indicator to help understand whether we reached the extreme point or not. If we have a historic performance upward (historic top) or downward (historic law) then again we are close to a turning point.
Because sentiment indicators are not available to all markets, a study of the financial media is appropriate. The extreme levels are often highly exposed by the media. In 2007 in Cyprus, six pages out of 40 of a newspaper were advertising properties. In 2009, the market had oversupply, diminishing the prices by 10% reaching today a decline of 20-30% of the prices in Nicosia.
Unrealistic valuation is also a good indicator that a turning point has been reached. Furthermore, best-selling books or films indicate that a particular market has already attracted the attention of the majority. Ravi Batra’s book on the coming depression became a best seller just after the crash of 1987. The news had been fully discounted. Don’t use politicians as an indicator because this is the most lagging indicator. When action is taken to fix something the opposite trend has already started. They will just confirm whether you got a turning point. A good example is what had happened with the banks during the last three years. In 2012, 10 bln were given to Laiki Bank (55.93% of the 2011 GDP) from ELA, in order for our leaders to decide that Laiki Bank is a non-viable organisation. Note, at that time Laiki Bank was offering a 5.5% interest rate.
The use of the above signs will help identify whether the market reached an extreme level in order to decide when to place your contrary opinion into action. We have to answer two big questions; when, and by how much. If the crowd reaches an extreme point, undoubtedly the market will decline, the unknown is only the time and the amount.
You have to decide on the ‘when’ going based on various information.
Interpreting bullish/bearish consensus numbers: If numbers are above 75%, that means that the market can be considered overbought, a top and a turning point is near. On the other hand, if the numbers are below 25%, it means that we have an oversold situation, both a bottom and wrong thoughts are near. Ask ten analysts about their thoughts. If 8 out of 10 has the same bullish opinion then it is the correct moment to take action.
Measuring the remaining buying or selling power left: If everyone has the same bullish opinion, then there is very little buying power left and the more likely the market to decline. This can be reinforced by the fact that if the majority has the same bullish opinion the market will become mispriced and alternative investments will become more attractive, giving higher probability for a market decline.
Be aware of the open interest: During a trend the volume should expand at the position of the primary trend, the open interest (new outstanding contracts). At the point that open interest becomes more and more flat, it is a warning sign because that means the trend is weakening and possibly you’re next to a turning point.
Finally, you have to watch the market’s reaction to fundamental news. The failure of prices to rise at bullish news indicates that you are ‘standing’ on a turn point. Remember what is going on with Apple’s share price, whenever it announces a new iPhone release and the stock price declines.