Contrary Opinion Forum

Each year at the Basin Harbor Club in beautiful Vergennes, Vermont the Contrary Opinion Forum meets. It is a three day gathering of contrarian minded investors and money managers. They share meals and hear distinguished contrarians offer their views on the state of the markets and new investment themes and techniques.

I have attended a few of these Forums and always returned home reenergized with new ideas and outlooks. Plus the Basin Harbor Club's setting amidst Vermont's beautiful wooded hills when fall colors are at their peak is worth the registration fee all by itself.

Take a look at this years schedule.

Is the recession over ?

Is the recession over? I think the odds favor the view that if it isn't already over it will end within the next couple of months. Of course, unemployment generally continues to rise even after a recession ends. But the fact that the stock market made a low nearly 5 months ago is a strong indication that economic activity will grow stronger as the months pass. Historically speaking, a stock market low precedes the end of a recession by less than 6 months.

The first chart above this post comes from the July 25 edition of the New York Times. It appeared in Floyd Norris' column. It depicts the behavior of the index of leading indicators near the troughs of recessions which occurred during the past 40 years. You can see that the index of leading indicators is trending strongly higher now and that is almost a sure sign that economic activity is starting to pick up and that the recession's end is imminent.

At the top of this post is an image of the latest Newsweek magazine cover. It depicts a balloon labeled "The Recession is over" about to be pricked and deflated by a pin labeled "good luck surviving the recovery". The cover story inside the magazine follows that theme. It says that even if a recovery has begun, it will be slow and that the next few years will feel like a recession anyway. Moreover, it goes further by asserting that this economic recovery will be qualitatively and quantitatively different from past recoveries - the damage done by the collapse in confidence will supposedly limit the economy's ability to grow for years.

From a contrarian traders's point of view this cover is more evidence that the bull market signal for aggressive contrarians will work out well. Newsweek is feeding the predjudices of the enormous bear market investment crowd that developed during 2008. But as prices rise this crowd will start to disintegrate and the resulting buying will provide a very strong upward impetus to the market averages.

One more observation: it is a well-established empirical fact about recessions that fast, deep declines in economic activity are followed by fast, steep recoveries. So Newsweek's prediction that this time will be different flies in the face of historical precedent.

A China Bubble ?

Every so often a new media theme catches my attention, usually because I see it mentioned in various publications and/or blogs within a fairly short period of time. Lately I have been reading about what some people claim is a "bubble" in the Chinese economy and/or its stock market. A weekly chart of this index is visible just above this post.

A couple of weeks ago an academic paper by some "econophysicists" appeared which asserted that a bubble in the Shanghai composite index had developed. At the top of this post you can see an image of the chart which appeared in that academic paper. The paper's authors concluded:

"By the very nature of the model, this result gives us two conclusions. Firstly, there exists a bubble in the Shanghai Composite Index. Secondly, it will reach a critical level around July 17-27, 2009. This will lead to a change in regime which may be a crash or a more gently bubble deflation. "

Is there really a China Bubble?

I don't think so and here is my reason.

It is always possible to recognize an incipient bubble by looking at the price chart of the asset in question. I discuss this point on pages 112-114 of my book. What should you see on the chart? Well, you should see a prolonged period of advancing prices, generally measured in years, which has brought the price of the asset to new historical highs. Do we see this the chart of the Shanghai composite index?

Definitely not. Prices have been rising for less than a year from a low point in 2008. And that low culminated a drop of nearly 75% in the index - a drop that doubtlessly produced an enormous bear crowd in the Chinese stock market. It takes a long time for extensive bearish sentiment to dissipate and be replaced by correspondingly strong bullish sentiment. Eight months is not nearly enough time - eight years is more like it. Moreover, as you can see on the chart, the index is trading at only about half the level of its 2007 high point. There won't be any possibility of a bubble until the index is at new historical highs above 6100.

So I think the prediction of the econophysicists will be proven wrong because they have ignored the nature of the mechanism which produces bubbles and subsequent crashes.

More bull market evidence

It is often hard to adopt a bullish stance after an extended bear market ends. This is even more true after a year long panic like the Panic of 2008. The relentless barrage of bearish news and commentary in the media affects even the most dedicated contrarian.

Sometimes an antidote can be found by looking at charts which depict the market's behavior from different points of view. If you have read my book you know that I like to use the S&P 500 composite index as my principal market indicator. This index appears as the middle chart above this post. The 200 day moving average of the S&P 500 is still dropping sharply. The conservative contrarian is waiting for this moving average to turn upward by 1% before moving to an above-normal stock market allocation. It looks like this move is still some months away. But by looking at the market from other perspectives the conservative contrarian can prepare himself mentally to make the switch at the right time with confidence.

The chart immediately above this post shows the Nasdaq composite index. It is behaving more bullishly than the S&P. It has already moved well above its October 2008 high point while the S&P is still 70 points below its corresponding high. The Nasday is more than 20% above its 200 day moving average while the S&P is only 12% above its moving average. The Nasdaq moving average has actually leveled out and appears ready to turn upward - there is as yet no sign of similar behavior in the 200 day moving average of the S&P 500.

The top chart presents the most bullish picture of all. It is a chart of the cumulative total of the difference between the number of advancing and the number of declining issues each day on the New York Stock Exchange. The blue line on this chart is the 200 day moving average of this advance-decline line. It has already turned slightly upward. The advance-deline line itself has risen above its August 2008 high, a level corresponding to the 1315 level in the S&P 500.

I think these charts show that the tide has turned. A new bull market has started. It will probably last through the end of 2010 and carry the S&P closer to its 2007 high at 1576 than anyone now imagines. But I think it is generally a mistake to invest based on forecasts. With this in mind the conservative contrarian should continue to wait for an up turn of 1% in the 200 day moving average of the S&P 500 before moving more money into the stock market.

A word to the aggressive contrarian. You took an above-normal long position at the 685 level near the March low point of 666. Follow the plan outlined on pages 133-34 of my book. Wait for six months to elapse from the March 6, 2009 low (i.e. wailt until early September). Then start watching the 50 day moving average of the S&P 500 (blue line in the chart). Once you see the 50 day moving average drop by 1% from a high point for the swing up from the March low reduce your long postion back to normal levels.

New Bull Market

Here is a daily chart of the S&P 500 covering the last year or so. Those of you who have read my book know that Wednesday was an important market event for the aggressive contrarian trader.

On pages 130-135 I described the market tactics I think an aggressive contrarian should follow. These tactics differ according to whether the aggressive contrarian believes the S&P 500 is in a bull market or a bear market. As I explained in my book, the simplest way to make this distinction is to compare the daily close in the S&P 500 to the 200 day moving average of these closes. A bull market is signaled when there is a close that is 5% higher that the 200 day moving average. This occurred for the first time in 18 months this past Wednesday when the S&P closed at 933 when its 200 day moving average was about 875.

At the moment, as I explained this this previous post, the aggressive contrarian already has an above-average long position. He did his buying in early March near the S&P 680 level. As I explained in that post and in my book the aggressive contrarian is waiting for September and for the first downturn in the 50 day moving average of the S&P that occurs after the first week of September from a new rally high. That will be his signal to reduce his long position from above normal to normal bull market levels.

How far might this bull market carry? As I explained in my book, historical precedent tells us that most bull markets last at least 20 months and carry the S&P 500 up at least 65% from its bear market low. Using this as a minimum expectation we would expect the S&P to advance to at least 1100 and reach its high in November 2010 or later.

The conservative contrarian is still waiting for an up turn in the 200 day moving average by at least 1% before he increases his long side exposure to stocks to above average levels.

That dog didnt' bark

Here is an hourly chart of the e-mini day session for the past six weeks. The rally from Monday morning's early low has been almost uncorrected - a very unusual show of strength. In my judgment the Goldman Sachs and Intel earnings reports were not by themselves enough to push the market up like this in normal circumstances. But circumstances are not normal. There is a very large investment crowd that is betting that this market will go a lot lower because the economy is deteriorating. The earnings news has put a small hole in that particular balloon - the economy may in fact not be deteriorating. And so many are so under invested that it doesn't take much to scare them back into the market. I think there is much more portfolio reinvestment to come as bears gradually give up the ghost. This market is headed much higher.

A contrarian goes to Barnes and Noble

I like to visit my local Barnes and Noble bookstore for a lot of reasons. One of the most important is the information I glean as a contrarian trader from the covers of the many magazines on display. The topics and titles of new books that appear on B&N's shelves is another good source of information. Even the number of shelves displaying business and investment books can reveal useful information about the strength of an investment crowd. I discussed this aspect of contrarian information gathering on pages 120-21 of my book.

I visited Barnes and Noble this past Saturday. Three magazine covers caught my eye. You can see images of them above this post.

The Harper's cover photoshops president Obama's head atop an image of Herber Hoover's body. The title of the story is "Barack Hoover Obama - the Best and Brightest Blow it again". The Forbes cover screams that congress is stealing the recovery. And at the top left of the same cover appears what will probably become known as the worst investment advice of the century: dump stocks, buy bonds.

The Business Week cover touches on a favorite theme of mine - retirement fears. The punchiness of the cover comes from the cover image: a graph of declining stock prices ending as the back of a beach chair. Note the use of the color red - the color of danger and fear.

These three covers tell me that the bearish investment crowd that developed during the Crash of 2008 has hardly diminished in size or intensity during the market rally since the March 2009 lows.

Light the torches, grab your pitchfork !!

Goldman Sachs is making money again!

Here is an image of today's front page of the New York Times. Note the story about Goldman's rumored profitable second quarter of 2009. It appears right under the headline story on the far right.

The article begins:" Most of Wall Street, and America, is still waiting for an economic recovery. Then there is Goldman Sachs". The story drips with envy, suspicion, and contempt for Goldman, evidently because they are making money by taking risks others are unwilling, unable, or fearful of bearing.

This is just one manifestation of the "lynch mob" mentality so prevalent among investors, the talking heads we see on TV and read on various blogs, and among the general public. Someone must be responsible for this disaster. We shall find them and they shall be made to pay for their crimes.

I discussed this phenomenon on pages 54-55 of my book. It is always associated with the emergence of a strong, bearish investment crowd and with the disintegration of the bullish crowd which preceded it.

This is more evidence that the low point of the Crash of 2008 was the 666 level established by the S&P 500 in March of 2009. Better times lie ahead.

The agressive contrarian vs. the S&P 500

In my book I devoted a great deal of attention to a trading style of the aggressive contrarian. This style involves taking above average long positions at times when bearish crowds are in control during bear and bull markets. Once the market rallies (I explained the specific rules in chapter 11 ) the aggressive contrarian will sell his position back down to normal in a bull market or below normal in a bear market.

As I explained in my book, the aggressive contrarian moved to a below-normal long position, his bear market stance, on November 27, 2007 when the S&P closed at 1,407, more than 5% below its 200 day moving average (red curving line on chart above). After a couple of profitable trades on the long side during the January-August 2008 period the aggressive contrarian came into September with a below-normal long position.

On pages 202-204 of my book I explained how the aggressive contrarian would have dealt with the September-November 2008 crash in stock prices. A bearish information cascade was visible in early October. Since the S&P 500 was trading at least 10% below its 200 day moving average then and since the market had dropped about two months from its previous short term peak on August 11 I explained that the aggressive contrarian would have assumed an above-normal long postions near the 1056 level early in the day on October 7.

This turned out to be a badly timed portfolio adjustment. After a rally from an 839 low on October 10 all the way back to 1044 in only two days the S&P resumed its drop. Its closing low for 2008 was 752 on November 20. During this drop the aggressive contrarian maintained an above-normal long position. Consequently during this 6 week period he underperformed the buy-and-hold benchmark strategy.

On page 204 of my book I explained why I thought the right tactic for the aggressive contrarian to follow going forward was to use the standard exit rule for bear market rallies: go back to a below-normal long postion on the first S&P close that is 1% above its 50 day moving average (the blue wavy line in the chart). This happened on December 16, 2008 when the S&P closed at 913. (I finished my book just a couple of days after the November 2008 low close of 752 in the cash S&P 500.)

The next opportunity for the contrarian trader came in early March of 2009. The S&P had established a short term top on January 6, 2009 at 935. Even at that short term top the average was trading more than 20% below its own 200 day moving average (the red curving line on the chart above). So the aggressive contrarian who was following the rules I set out in my book would only have to wait for 60 days or so to pass and for a bearish information cascade to become visible in the media as the market dropped. At that juncture he would again move to an above average long position.

I track information cascades in my contrary opionion posts that you can find at this link. In particular I want to point out the posts of March 3 and March 6 .

The headlines cited in these posts occurred almost 60 days after the January high at a time that the S&P 500 was trading at least 10% below its 200 day moving average. According to the rules the aggressive contrarian would have been justified in moving to an above average long position on March 9 with the S&P at 677.

As I explained in this post I thought that the rally from the March 2009 lows was the start of a new bull market. With this in mind I think the aggressive contrarian would be following the rules I outlined in my book on page 133 that deal with a rally which is likely to be the first leg of a new bull market. The aggressive contrarian is waiting for a new rally high in the 50 day moving average (the blue wavy line in the chart above) that occurs on or after September 6, 2009. Once this happens he will move back to either a normal or below normal long postion in stocks.

Gloom

Here is a screen shot from today's Instapundit blog. I am posting it because it gives me a chance to make an important point about investment crowds.

As you know if you have read my book or followed my blogs I think that an enormous bearish crowd developed in the stock market during 2008-09. It is certainly bigger and more unified in its bearish convictions about the economy and the stock market than any I have seen since 1966. Bearish crowds this big don't disintegrate quickly. And the screen shot above is just one sample of the relentless negative story about the economy that is still being told by the media.

Such stories belie the assertions I have heard from bearish market commentators recently that "everyone is bullish and euphoric" about the stock market. The public is decidedly NOT euphoric. Quite the contrary, it is depressed - much more depressed than is the economy, in fact. It will be years before the psychological damage wrought by the Crash of 2008 is undone.

As a side note I might also point out that the "everyone is bullish and euphoric" theme is a typical mistake made by investors who like to think they are contrarians. They seize on whatever evidence they can find that makes their own prejudices a "contrary" opinion. But one must be careful to fade the public, not some small group of professional market commentators. And there is no doubt in my mind that the public right now is extremely bearish.

Crude Oil Update

Here is an image of today's front page for the New York Times. The headline tells us that Washington's regulators are considering limiting the size of positions taken in crude oil futures by certain "financial" speculators.

This headline goes into my media diary along side the one from two day's ago which I commented on in this post. It is highly unusual for two headlines to appear in the same week, in the same publication, which highlight activity in a commodity market. This one, like Monday's headline, worries about market volatility. Now no one worries about volatility in crude oil when the market is going down. They only worry when it is going up. So these two headlines give the aggressive contrarian reason for thinking that crude oil is headed down to $36 or below over the next few months. It is still a bear market in crude.

A Contrarian Looks at Crude Oil

Here is an image of today's front page of The New York Times. It is very unusual for a commodity market, even one as important as crude oil, to be the subject of a page 1 headline. So when I saw this I immediately cut it out and pasted it into my media diary.

How would a contrarian trader interpret this headline? Is there an obvious bullish or bearish investment crowd dominating the crude oil market?

The first step towards answering these questions is to look at crude oil's price chart. As I emphasized in my book, this is the single most important clue that reveals whether an investment crowd has formed in any market. (See page 112 of my book. ) I see two important things when I look at this chart.

First, the price of crude oil has doubled in the last few months. This alone makes it highly unlikely that any bearish investment crowd is dominating the market for crude oil. A 100% advance in price attracts bullishly inclined traders and investors, not bearishly inclined ones.

If no bearish crowd is in evidence, then how about a bullish one? Here too the price chart makes me skeptical about this possibility. Firs of all, the price of crude oil has risen for only six months or so, doubling during this time. In my experience this is just not enough time to get a bullish bandwagon rolling. Moreover, you can see from the chart that crude is still well below its all time high of $147 which was reached in July 2008. It is very unlikely that a bullish oil crowd will form unless and until the market approaches that $147 level. The situation now is in marked contrast to that which prevailed back in July of 2008 when crude established its $147 high. I discussed the peak oil crowd and its domination of the crude oil market on pages 23-24 and 70 in my book - those pages were written in late July and early August of 2008.

So right now I don't think the contrarian trader can interpret this New York Times headline as evidence for either sort of investment crowd. Still, the headline is intriguing. A very aggressive contrarian trader who is more concerned with shorter term price fluctuations might see this as an opportunity. Here's why.

The first paragraph of the headine story makes it clear that it is the doubling of oil prices that is the motivating fact for the headline. The article is all about extreme volatility in the oil market, but when it comes to commodities the real concern is upside rather than downside volatility. On page 59 of my book I talked about the emergence of volatility as a sign of the imminent demise of an investment crowd. These considerations all suggest that this headline can be interpreted as evidence for the existence of a bullish market crowd, although not one of a size even remotely approaching the one which dominated the market back in July of 2008.

So I think that a very aggressive contrarian would see this headline as evidence that crude oil is about to drop subtantially. On the price chart above you see the red line which is the 200 day moving average of crude oil prices. It is still headed downward which is evidence that crude oil is probably still in a bear market. In a bear market any bullish investment crowd is likely to be short lived. So the combination of the doubling of price over the past six months, the New York Times headline, and the declining 200 day moving average all point to an imminent drop in crude oil.

How low might it go? Well, since this is still a bear market my best guess would be back to last December's low near $35, if not lower.