Be Right When Everyone Else Is Wrong

This article reprinted with permission from InvestmentU.com.

"Stocks are going to head higher. There is nothing out there to push them lower."

"Stocks will crash and continue lower for the next several years."

What would you do if you heard either of those statements? If I heard the first one and markets had been rallying for a while, I'd get defensive. That statement is a sign of hubris.

If stocks had been falling and I heard the second statement, I'd be getting ready to pull the trigger on some stocks on my buy list.

Those are examples of sentiment being at extremes, usually at the exact wrong time. When things get bad, people - even experts - make definitive statements based on fear. When the market has been strong for a while, the same thing happens, but then it's based on greed and the feeling that stocks will never go down again.

Even professionals with decades of experience are susceptible to strong emotion. The problem is that when sentiment reaches extreme levels, markets usually do the opposite. That's because when there is extreme optimism, there's no one left to buy - everyone is invested. Extreme fear means people have likely already sold their stocks, so when the buyers come in, there are no sellers to hold down the stock prices.

If you trade the opposite of extreme levels of sentiment you'll likely be investing during the bottoms and getting defensive at the tops.

Here are a few indicators to help you determine when the time is right to go against the crowd.

The Magazine Cover Indicator

When there is extreme bullishness or bearishness and a major magazine agrees with the sentiment with a cover story, that's usually the time to go in the opposite direction.

This indicator first came to prominence in 1979, when Businessweek ran a cover story titled "The Death of Equities." The 1970s were a poor decade for stocks. From January 1, 1970, to August 13, 1979, the day that the Businessweek issue hit the newsstands, the S&P 500 had gained only 15% in nearly 10 years. The economy was in shambles, inflation was sky high and the market was not a particularly attractive place to put your money.

So when Businessweek ran its now-infamous headline, it seemed to make sense. Only it didn't work out that way.

The market went on a historic bull run. The S&P 500 gained 52% over the next five years, 222% over 10 and 20 years later had climbed 1,111%. Not exactly the death of equities.

Not to pick on Businessweek but in 2008, they ran two covers on housing stating that the worst was yet to come. Again, it made sense at the time, but we know now that housing rebounded a short time later.

So when you see a magazine cover during times of extreme optimism or pessimism that agrees with that emotion, think about going in the opposite direction of that sentiment.

Put-Call Ratio

The put-call ratio measures how many puts are being bought versus how many calls. Puts are bets that an asset is going down in price. Calls are a bet on higher prices.

When the ratio is high, that means significantly more puts are being bought than calls, signaling extreme fear or bearishness. The opposite is true when the ratio is low. When it spikes higher during market downturns and plunges lower during strong rallies, that usually suggests a market reversal is coming.

Sentiment Surveys

There are various surveys out there that try to gauge the sentiment of individual as well as professional investors.

The AAII Investor Sentiment Survey is one of the most well-known. That survey measures the responses of individual investors. Same as the other sentiment indicators, it is most effective at extremes. Currently, both bullishness and bearishness are slightly above their long-term historical average, while neutral sentiment is below. That doesn't tell us much. But if the market rallies again and bullish sentiment jumps, you might want to think about some defensive measures.

There are other surveys that measure fund managers and even one that considers the sentiment of newsletter writers. And just like all other sentiment indicators, when they are solidly on one side of the bullish/bearish argument and that is in agreement with the direction of the market, the winds of change are likely to be a blowin'.

Outrageous Statements

When markets are at extremes, people say stupid things and write ridiculous books.

During the bull market of the dot-com boom, there were all kinds of investing books published about how much money you could make in the market. But in 1999 we saw titles like Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. That should have been a hint that the bull market was nearing its end.

For a more recent example, consider what happened last week. As bond yields were plunging, famed bond investor Jeffrey Gundlach declared 2.2% would be the bottom for 10-year Treasury yields. That call was good for about 14 hours as yields tanked the next day and hit a low of 1.87% that morning.

And as oil was plunging last week, an analyst from Commerzbank said, "There is no end in sight to the downward spiral" in oil prices. Those kinds of statements are typically made at the bottom of moves, not when violent downturns are just beginning.

Just remember to use sentiment indicators during periods of extreme greed or fear. Think back to the dot-com days or housing in 2006 for examples of extreme greed. Or the financial crisis of 2009 or even oil's fall last week for instances of fear.

The next time you think we're at extreme levels of bullishness or bearishness and see sentiment is in the same direction, start looking for opportunities to go against the crowd.

Marc Lichtenfeld is chief income strategist at InvestmentU.com.

The information contained in this article should not be construed as investment advice or as a solicitation to buy or sell any stock. Nothing published by Physician’s Money Digest should be considered personalized investment advice. Physician’s Money Digest, its writers and editors, and Intellisphere LLC and its employees are not responsible for errors and/or omissions.