Efficient markets should incorporate all available information into the price of an asset. However, there is not just a lag between a data announcement and the change to the price, but periods where a market will be overbought or undersold. What is an explanation for these instances? Is it due to investor emotion? That’s where a contrarian indicator comes in.
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Contrarian Indicator Introduction
While most investors would like to think that they make sound decisions due to a Fear of Missing Out (FOMO), many will have bought near highs and sold near lows due to panic. These herd behavioral actions are called market sentiment. When sentiment is high, the majority thinks value will rise; however, they are often wrong rather than right; the market usually moves against the majority’s sentiment. Professional money managers and traders use the market’s sentiment as a contrarian indicator, buying when pessimism is highest and selling when it is the most optimistic. Several contrarian sentiment indicators can be utilized for trading.
The AAII Sentiment Survey is published once a week and can be found HERE. It is a survey of AAII site members asking if they feel bullish, bearish, or neutral about the stock market movement over the next six months. It is a voluntary response, and the average AAII member and respondent is:
- Male
- Approximately 60 years old
- Has a graduate degree
While this is not the typical citizen, the survey represents active, hands-on individual investors near retirement age with substantial portfolios. The accuracy of this contrarian indicator has been proven rather accurate. There was an end-of-September fall in the market followed by a recovery just after the bearish high for the index, the perfect time to buy.
Bullish Percentage Index (BPSPX)
The Bullish Percent Index for the S&P 500 (red and black) is shown with the S&P 500 in dotted green. The raw chart can be found here.
The BPSPX looks at a group of stocks, recording the percentage of those stocks with a Point and Figure Buy Signal from their point and figure chart. The BPI for the S&P 500 looks at 2.5 years.
If the BPI exceeds everything, it is good; above 65 will indicate a correction and a dip-buying opportunity; below 65 indicates a more serious correction is coming. Finally, if the signal drops to 25, this indicates a short-term bottom. The current chart shows a future correction, especially if it breaks out of our blue lower trend line.
CBOE Volatility Index Contrarian Indicator
The CBOE Volatility Index or VIX, also known as the “fear gauge,” is calculated in real-time by the Chicago Board Options Exchange (CBOE). The VIX is a weighted blend of options on the S&P500 index. Options prices will generally increase with higher volatility, and the VIX will also jump with increased volatility or an expectation of it.
The VIX is used to indicate market peaks and valleys. The above figure shows how the blue peaks of the VIX will correspond to lows of the S&P500; the May 12th and September 20th peaks had 100 points S&P 500 climbs that followed.
Put Call Ratio (PCR)
The put-call ratio takes the ratio of put trading volume divided by the trading volume of calls. Investors will purchase puts to protect themselves from a market downturn and call to benefit from a bull rally. If there are a large number of puts in comparison to calls, this is an indication of low investor sentiment. You can see the most up-to-date ratio from the CBOE by clicking HERE.
If the put-call ratio is above one, then investors are protecting their assets from downside risk. If the ratio continues to rise it is more pessimistic, and this is a signal of a market bottom. As the ratio begins to drop, investors are more complacent and may eventually become overly optimistic, which could be the case with our current ratio below .70.
Fear Greed Index Contrarian Indicator
Several Fear and Greed indexes have been developed; a fairly accurate one has been developed by CNN Money and is presented in real-time. It looks at seven indicators often used to determine sentiment (including the put-call ratio and the VIX) and combines them into a single metric.
These are the items used to make the CNN index:
- Stock Price Momentum: Takes the S&P 500 against its 125-day moving average
- Stock Price Strength: The number of stocks hitting 52-week highs and lows on the New York Stock Exchange
- Put and Call Options: The put/call ratio, see above
- Junk Bond Demand: Spread between yields of investment-grade bonds versus junk bonds
- Stock Price Breadth: Volume of shares rising versus those falling.
- Market Volatility: The VIX seen above
- Safe Haven Demand: The difference between returns for stocks versus that of Treasuries
The market lows will usually occur with “extreme fear” and will top out with “extreme greed.”
Final Thoughts
Contrarian indicators are excellent for ensuring you are not falling into a herd mindset that can result in severe losses. None of these indicators should be used independently to make a trade decision. They should be incorporated into an overall strategy. But also don’t double-dip. The fear and greed index considers both the put-call ratio and the VIX, so don’t think that a combination of all three is a sign that things are good or bad when they are not just correlated but the same.
As always, never put yourself at risk with one position more than you are willing to lose, and good luck with all your trades.
