My top three contrarian indicators

I am a contrarian investor by nature. When there is too much fanfare around an investment, be it a stock or whole asset class, I usually find myself wanting to run for the exits. The hair on the back of my neck literally stands on edge sometimes. Most value investors tend to be at least somewhat contrarian. You almost have to be to buy cheap asset classes which by definition are unloved. Besides applying my contrarian nature in looking for cheap dividend paying stocks I also monitor the overall market for signs of what asset classes and when it may pay even more to go against the flow. After all, even cheap stocks tend to get cheaper in weak markets and vice versa. In this post I describe my three favorite contrarian indicators.

Probably my favorite contrarian indicator is money flows. Many investors buy high and sell low no matter what lessons they think the have learned. Emotions are tough to overcome. The Investment Company Institute publishes weekly money flows for long term mutual funds. It is a great resource for contrarians. Here is the latest data as of May 18th. Longer term data is also available in an excel download on their website.

So what does this data tell me? A few things. Based on the last three week’s of domestic equity mutual fund outflows I’m becoming a little more bullish on stocks. This type of data in general is best at extremes but this is a sign that investors are scared of a downturn in stocks and are pulling money out of US equity mutual funds. Something to keep an eye on. Next, the data tells me that US taxable bond funds continue to be very strong. The data on this sector has been strong for many months despite all the hype in the press of rising interest rates. Here that data is telling you that there is strong demand for US bonds and it does not appear to be slowing. Lastly, the data tells me that the tide may be turning for muni funds. After negative outflows going back to November 2010 money has started to flow back in to muni funds. The levels are still small but I will be watching this data for signs investors are becoming too bullish on munis.

The next indicator I like to watch is investor sentiment. AAII publishes a weekly investor sentiment index which I use as a contrarian indicator as well. Below is the latest data. You can sign up to receive a weekly email of the sentiment survey and there is a great article on how to use the data as a contrarian indicator.

This latest data tells me that investor have become a bit more bearish, and less bullish, than the long term averages of the survey potentially indicating positive performance for stocks to come. Like with the previous data, this one is better as it gets to extremes but for now it tells me to be on the lookout for a potential buying opportunity to come.

The third indicator I like to use is outstanding margin debt. When investors get very positive on stocks they tend to buy stocks more and more on margin, i.e. borrowing money from the broker to buy stocks. At extremes this usually gets investors into trouble as even small negative events can lead to margin calls which lead to even larger price declines. The NYSE published margin debt data every month and their is a nice chart available at Bloomberg. Below is a 5 yr chart with the data as of the end of April.

This data would tell me to be very careful. Margin debt has climbed back to almost pre-crisis levels and events that triggered small declines could then to lead to larger declines if margin calls began. The problem with this indicator is its timeliness. There is only monthly data released as opposed to weekly data with the other two indicators. I think when the May numbers are released we’ll see a decline in margin debt due to the recent mini correction in the energy and commodity sectors. Nevertheless, I think it is a another good version of a sentiment indicator to keep an eye on.

Those are my top three contrarian indicators. I use a few others for my options trading, the VIX and the CBOE Put/Call ratio, but these are the big ones that I try to use to add value to my investing. In the past 6 months or so these indicators have caused me to keep my cash position high, strong US equity flows – high investor bullishness – high margin debt, while still taking advantages of opportunities that arose, like investing in muni bonds. Now some of the indicators are starting to signal potential opportunities in stocks but it may be too early. Time will tell.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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8 Responses to My top three contrarian indicators

  1. Chris Ayoub says:

    I agree with your notion, and history has proven it out, that when everyone wants in, it’s time to get out and vice a versa. The likelihood is that a degree of pain will be incurred early on when implementing a contra strategy, but with patience and a strong stomach, an investor should ultimately be rewarded. In this regard, should we be exercising a little more caution with respect to MLP’s. This asset class has the complete attention of the average investor looking for yield and there has been huge inflows of capital into them. Watch out when the party is over.

    • Mark says:

      I think that especially applies to MLP’s, many, if not all, currently priced to perfection and as Chris notes a popular investor darling. I’m not sure where to look, possibly muni’s or financials if one wants to play uber contrarian, but I’m letting further investments in MLP waters wait for better days.

      • libertatemamo says:

        Mark, I’m with you on letting MLP investments ride for a while. As far as what is cheap out there…that’s a tougher call. Munis, yes, still cheap but not as cheap as before. Financials, yes even cheaper, but the gov’t and balance sheet headwinds they face are huge looming issues I want no part of. The only financial sector I like is insurance companies. They are quite cheap. Fairfax, Aflac, some international players. Strong and cheap. Also, mortgage REITs in a continued low rate environment are cheapish. Then there are the home builders….cheap but with no visible catalyst in the near future…no thanks. Big tech…cheap with strong fundamentals with 2H 2011 seasonal catalysts coming…

        My 2 cents anyway.


    • libertatemamo says:

      Hey Chris, I do think caution is warranted in MLPs at this point. They are not cheap by any means but they are not too expensive either. Using spreads to the 10yr as an indicator they are trading at slight below, i.e slightly more expensive, their historical average. Of course this is mainly due to the low level of the 10 yr note yield. Personally, I think low interest rates are here for a very long time, longer than most people think. Also, the popularity of MLPs is only set to increase due to the yield seeking aging population. I often compare them to utilities – besides the tax risk why on earth would MLPs trade at a discount to the utility sector which trades at an average yield of 4%. The underlying fundamentals of most MLP businesses are much much stronger than most utilities. Maybe we should thank our lucky stars for the tax risk….it still keeps many investors away. I just look at the popularity of junk bonds and real estate REITs and think MLPs still have a long way to go.

      I’m not adding to the sector, I’m patient and have a strong stomach. I would love to see a 50% correction in the space. 12% yields! bring it on.


  2. J Carroll says:

    Paul, do you see any value in option premiums as an indicator? For example, UNG is currently at $11.48, and the $12 call expiring 110716 (slightly out of the money and 7 weeks to expiration) is $0.36; that’s a huge premium. Thank you.

    • libertatemamo says:

      J, yes I do but at the macro level. The VIX and the NASDAQ VIX, can’t remember the symbol, are good contrarian indicators. The only issue is that they tend not to be leading indicators. The VIX can go from 15 to 50 in a few trading sessions. I tend to use the VIX indicators for option trading only. Individual issue option premiums each have their own story usually. In your example, UNG, I would not consider the 36 cent premium huge, its 3% for 7 weeks. Not that big. Its all due to the implied volatility. For example, just picking a random high flier. The Netflix June 18 $265 calls, expiring in 21 days, have a premium of $8.58, or 3.2%. That’s a bit bigger. Back in 2008, with the VIX at 80 you could sell puts on deeply discounted stocks with 10% premiums for 1 month options. That is huge! Again, its all about implied volatility with options.

      BTW, UNG is an awful ETF. Investors have lost more money in UNG than the underlying loss in natural gas futures themselves. Its called roll risk and UNG is full of it.


      • Chris Ayoub says:

        I agree with Paul’s assessment of UNG. Before anyone puts money in, you need to read the prospectus. They indicate that shareholder interest is not a priority in managing the fund.

  3. Pingback: Update on contrarian indicators – sit tight for now « Investing For A Living

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