Thursday, July 9, 2009

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.

1 comment:

  1. Gooooooooooooooood
    Thank you
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