One Contrarian Indicator You Can’t Ignore

| September 3, 2010 | 0 Comments

Sheep get sheared…

For the one billion sheep on farms around the world, it’s a fact of life. They’re going to get clipped.  The wool they’ve worked so hard to grow all year will be snatched from them in an instant.

If you’ve ever been on a ranch, you quickly see sheep have a natural tendency to follow a leader.  They move together as one big flock.  And they get stressed if they’re separated from other flock members.

A flock mentality is a great defense mechanism in the wild.  But it’s disastrous when it comes to investing.  And it’s a sure fire way to get your bank account clipped.

In other words, following the investing crowd is a big mistake.

The crowd phenomenon can be seen throughout history with examples like the Dutch Tulip Craze and the South Sea Bubble dating back to the 1700s.

It was even popularized in 1841 by the book, Extraordinary Popular Delusions and the Madness of Crowds, written by British journalist Charles Mackay.

Clearly, following the crowd has a long history of ending badly.

In fact, individual investor sentiment is a great contrarian indicator.  When individuals are overly bullish, it’s usually a good time to sell.  And when they’re overly bearish, it’s usually a good time to buy.

Here are just a few recent examples of investing with the crowd gone horribly wrong.

Back in the early part of 2000, we were at the height of the dot-com boom.  Everyone was sure the tech stocks would go up forever.  At the time, the crowd thought the “new economy” was immune to the business cycle.

Bullish sentiment was at all time highs.  Everyone wanted to own stocks. But if you followed the flock, you got burned when the tech bubble burst.

And don’t overlook real estate in 2006.

At the time, everyone knew real estate didn’t go down in value.  People were “flipping” houses left and right.  All you had to do was buy houses then wait a few months to resell them for a profit.  I saw that happening all the time here in Phoenix.

And just like tech investors in 2000, the real estate crowd was wrong.  The real estate bubble burst and followers who were late to the game were left holding the bag.

But that’s not all…

Just the opposite is true when investors get overly bearish.

Remember March of 2009?  In the wake of the 2008 financial crisis, nobody wanted to own stocks.  Investor sentiment was extremely bearish.  Then the S&P 500 shot up 83% over the next 13 months!

If you followed the crowd, you missed out on a huge opportunity.

And this is only a small sampling.  History is littered with examples.

Fast forward to today.  The Investor Intelligence Poll shows investors are throwing in the towel.

More than 37% of investors are now bearish on stocks.  And bulls sank to under 30%.  It’s the first time since March of 2009 sentiment has been this bearish.  We’ve seen this situation before.

This is an extreme level of bearish sentiment.  And more often than not, extremes in market confidence are market turning points.

Remember the lessons history has taught us.  Following the crowd isn’t the way to achieve your financial goals.  Go against the grain.  It may take you out of your comfort zone, but you’ll be better off in the end.

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Category: Stocks

About the Author ()

Corey Williams is the editor of Sector ETF Trader, an investment advisory service focused on profiting from ETFs and the economic cycle. Under Corey’s leadership, the Sector ETF Trader has become one of the most popular and successful ETF advisories around. In addition to his groundbreaking service, Corey is the lead contributor to ETF Trading Research, where he shares his insights about ETFs and financial markets on a daily basis. He’s also a regular contributor to the Dynamic Wealth Report and the editor of one the hottest option trading services around – Elite Option Trader.

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