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.