Tuesday, June 23, 2009

The stock market crowd

Chapter 15 of my book is entitled "The Panic of 2008". It documents the enormous, bearish information cascade that progressed through the year. Magazine covers and newspaper headlines documented and amplified investor fears. Eventually a run on the "hidden banking system" developed after the Lehman Brothers bankruptcy on September 15, 2008. Markets around the world crashed and took the world trading system and economy with them.

You can find my real time comments on this information cascade at this link. Every time I imagined the news couldn't get worse, it did. By the end of the year an enormous, bearish investment crowd dominated world stock markets. The vast majority of investors and ordinary citizens shared a very pessimistic outlook for the U.S. and world economy.

I think this bearish investment crowd presents a once-in-a-lifetime opportunity to the contrarian trader. The investment policy for a conservative contrarian is described in my book on pages 129-130. I call it the Contrarian Rebalancing Strategy. At this point in time the conservative contrarian would have a normal allocation of his investment portfolio to the stock
market. In my book I tool the normal portfolio allocations as 60% stocks, 30 % bonds, and 10% cash.

Since a bearish stock market crowd is very much in evidence, the conservative contrarian is now waiting for the 200 day moving average of the S&P 500 to turn upward by 1% from the lowest point is has reached since 2007. As you can see from the chart above (courtesy of StockCharts.com) the 200 day moving average (red line) is still dropping and currently stands at 899. So a 1% advance in this moving average still lies some months ahead of us. When this 1% advance in the moving average occurs I think the conservative contrarian should then put all of his non-cash assets into the stock market.

You may wonder why the conservative contrarian currently has a normal instead of a below-normal allocation to the stock market. I have long maintained that the worse mistake any investor can make is to be underinvested during an extended period of rising stock prices. Such a mistake would cause his investment performance to lag that of the benchmark buy-and-hold strategy. For this reason I think a conservative contrarian should only have a below-normal stock market allocation when there is strong evidence for a bullish stock market crowd. Even then, he should wait for the 200 day moving average of the S&P 500 to drop by 1% before reducing his stock market allocation.

In the present context everything hinges of whether or not a contrarian trader/investor thought there was a bullish stock market crowd dominating the market in 2007. I for one did not and I said so in my book. My media diary did not show any evidence of a bullish information cascade in the stock market. So a conservative contrarian who shared my analysis would have maintained a normal stock market allocation throughout the panic of 2008. (Of course he would have had a substantial reallocation away from bonds and into stocks at the end of the year simply to maintain his 60-30-10 portfolio shares for stocks, bonds, and cash. ) Despite this, he lost no ground to the benchmark buy-and-hold strategy during the panic (cold comfort, I know!).

There were some contrarians who did think a bullish stock market crowd was evident at the 2007 top. If they had followed the moving average strategy described above to reduce their stock market exposure they would have done so on February 20, 2008 at the S&P 1360 level as pointed out in my book on page 190. Right now these contrarians would be sitting with below-normal stock market allocations and would be awaiting a turn upward in the 200 day moving average by 1%. They too would move to an above-normal stock market allocation when this signal occurs.

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