Thesis on "Contrarian Investment Strategies"

Thesis 73 pages (26080 words) Sources: 60

[EXCERPT] . . . .

Contrarian Investment Strategies

Over the last several decades a number of different investment strategies have evolved. All of them were designed to help investors be able to successfully time the up and down moves, that occur on the world equity markets. However, the overall results have varied dramatically as investors, traders and analysts argue about which theory is the best one to achieve this objective. At the heart of this argument, is the belief that the markets will overshoot in both directions. Where, some will claim that the markets reflect all expectations and available information in the price of the stock (commonly called the Random Walk Theory). This makes it impossible to determine if the markets will move up or down-based past market conditions. While, contrarian investors will argue that the markets are known for large amounts of volatility. This is because the markets are run by the emotions of fear and greed. During times when the economy is expanding and the averages have outperformed their historical rate of return, is when the emotions of greed will affect investor psychology. At which point, the markets will form bubbles that are created by this chasing mentality, that is affecting both the individual and professional investor. It is at this point that the market is overvalued because of these emotions from the crowd, where a major reversal is more than likely to occur at some point in time. During those times when the economy is performing poorly, is when the markets will become undervalued. This is because the emotions of fear are causing the majority of investors to become risk adverse. As a result, they sell their most liquid and volatile assets (stocks / options) first. Once this take place, it means that a wave of selling will drive stock prices lower. According to contrarians, these two extreme moves that are occurring in the markets allow all investor to be able to take advantage of the price irregularities that are occurring. Where, the prudent contrarian investor will short or sell stocks when the crowd is optimistic. Then, once the crowd is no longer interested in stocks, is when they are able to buy many companies at a fraction of their value. This gives them a much better return, because they were able to take advantage of these irregularities.

To determine if the contrarian investment strategy is effective requires examining how this strategy has been able to predict major market reversals. This will be accomplished by: examining the different approaches used by this investment strategy, how the use of different contrarian indicators can predict major market reversals, which contrarian tools / indicators are the most useful and analyzing the different trading strategies. Together, these elements will provide the greatest insights as to how effective the contrarian investment strategy is in determining the movements of the major stock market averages.

The Different Approaches used by the Contrarian Strategy

What is a contrarian strategy?

A contrarian investment strategy is when you are monitoring the general mood of investors to determine if market prices are over or undervalued. This is because investors / traders are affected by one of several different situations that will help contribute to the overall emotions being felt with investing to include: placing more of an emphasis on current information, panics and not being able to fully understand the financial terminology or how the various financial-based products work. Investors generally will place more importance on information that was received most recently, rather than examining the trends of the underlying stock. This means that when a company reports much better or worse earnings, there will be a sharp volatile move reflecting these emotions. Panics have the ability to feed upon themselves, where a certain amount of selling or buying will take place based on perceptions about what is going to occur. During times, when the news is negative this can cause a panic, with investors wanting to sell their stock at any price. Then, there are the programmed sells such as sell stops. This is an order to sell a stock that is determined in advance. During panics, these stops trigger even more selling, as stock prices break through key levels of support. The overall complexity of various financial products such as: swaps and derivatives trading causes even more emotionalism with investors. This is because these kinds of investment products are complicated and unknown to the average investor. When someone purchases something that they do not understand and it begins to decline, there is the possibility that investors will become worried about severe losses. Once this begins to take place, is when investors will become emotional.

At which point, the overall amounts of volatility will increase. What this shows is that the different factors can work together or separately to cause the investor to question their motivations for buying or selling a particular asset. This is when they will begin to question the decision and engage in actions to rectify the situation. When millions of investors are doing this, it means that the stock market averages will have volatile movements. At which point, the chances increase, that markets will become too expensive or to undervalued because of these emotions.

What does contrarian investing capture?

Contrarian investing captures the emotional sentiment of the investing crowd. This is important because this information is used to help make investment decisions going forward. However, in some cases these issues of sentiment that have been identified; will point to the strength or weakness of the underlying trends in the market. Where, contrarian indicators will show that the markets are overbought or oversold, yet there is enough demand for stocks from investors that the trend will continue.

What this captures, is the overall feelings from investors and traders, prior to a major reversal in the markets. This could take place over the short-term or the underlying trend could continue until the forces of supply and demand become more imbalanced.

What is the interpretation?

The interpretation of the contrarian thinking is to be able to identify changes that are taking place early in the trend. Where, contrarian thinking will help provide a general overview as to if the price of the stock / markets are over or undervalued. However, the majority of investors do not understand that when a contrarian buy or sell signal appears and that it must be correlated with other information. This is because once a buy or sell signal emerges, it could take several days or years to see the actual change in trend. An example of this occurred during the bear market of 1973 to 1974, with the Dow Jones Industrial Average, where the markets were indicating in mid-1974 that equity prices were becoming severely oversold. However, the bottom in the market averages would not occur until late 1974, as this would spark a rally in asset prices that would last until 1977.

The Use of Different Contrarian Indicators to Predict Major Market Reversals

The continuing debate that is often very heated among Wall Street analysts, traders, investors and economists is: the overall effectiveness of contrarian thinking. This is because many investors will argue that purchasing stocks that mirror the major market movements will provide more diversification and protect for your portfolio from the volatility, which often accompanies volatile stocks. As a result, they believe that the long-term market averages will provide more consistent returns than effectively trying to time the markets. An example of this can be seen with a contrarian investment strategy called vulture investing, where investors are purchasing the common stock and the debt of those companies that are on the verge of bankruptcy. The idea is that investing in these kinds of companies, there could be possible situations such as: an acquisition or merger; that would change the fortunes of the company. Once this occurs is when these investors will see a dramatic appreciation in their investments.

While this is true to a certain extent, these skeptics are ignoring the fact that contrarian thinking is not speculation. Instead, contrarian investing is when you are using the market conditions and the emotions tied to a particular stock / the markets, to determine if it is overbought or oversold. An example of this can be seen with comments from Ben Graham (who was an advocate of the valuation / contrarian approach to investing) where he said, "What do we mean by investor? We attempted a precise formulation of the difference between the two, as follows. An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative. We have clung too tenaciously to this definition over the ensuing 38 years. After the great market declines of 1929 -- 1932 all common stocks were widely regarded as speculative by nature. (a leading authority at the time stated flatly that only bonds could be bought for investment). Thus, we had then to defend our definition against such charges that gave too wide a… READ MORE

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