CONTRARIAN STRATEGIES

A contrarian is one who attempts to profit by investing in a manner that differs from the conventional wisdom, when the consensus opinion appears to be wrong.  It can be a trader’s strategy that goes against prevailing market trends by buying assets that are performing poorly and then selling when they perform well. A contrarian strategy believes that those who say the market is going up do so only when they are fully invested and are out of capital. At this point, the market is at a peak. Likewise, when people predict a downturn, they have already sold out, at which point the market can only go up.  A contrarian strategy can also emphasizes out-of-favor stocks with low P/E ratios.

A contrarian believes that certain crowd behavior among investors can lead to exploitable miss pricings in stock markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company's risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains. Likewise, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don't pan out. Avoiding (or short-selling) investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether an individual stock, an industry sector, or an entire market.

Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overall stock market, nor does he have to believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced.

Contrarian investing is related to value investing in that the contrarian is also looking for mispriced investments and buying those that appear to be undervalued by the market. One possible distinction is that a value stock, in finance theory, can be identified by financial metrics such as the book value, earning per share (EPS) and/ or P/E ratio. A contrarian investor may look at those metrics, but is also interested in measures of "sentiment" regarding the stock among other investors, such as sell-side analyst coverage and earnings forecasts, trading volume, and media commentary about the company and its business prospects.

Although more dangerous, is shorting overvalued stocks. This requires 'deep pockets' in that an overvalued security may continue to rise, due to over-optimism, for quite some time. Eventually, the short-seller believes, the stock will 'crash and burn'.

Commonly used contrarian indicators for investor sentiment are Volatility Indexes (also referred to as "Fear indexes"), like VIX, which by tracking the prices of financial options, gives a numeric measure of how pessimistic or optimistic market actors at large are. A low number in this index indicates a prevailing optimistic or confident investor outlook for the future, while a high number indicates a pessimistic outlook.

Another contrarian strategy is Dogs of the Dow. When purchasing the stocks in the DJI that have the highest relative dividend yield, an investor is often buying many of the "distressed" companies among those 30 stocks. These "Dogs" have high yields not because dividends were raised, but rather because their share prices fell. The company is experiencing difficulties, or simply is at a low point in their business cycle. By repeatedly buying such stocks, and selling them when they no longer meet the criteria, the "Dogs" investor is systematically buying the least-loved of the Dow 30, and selling them when they become loved again.

Contrarians are attempting to exploit some of the principles of behavioral finance, and there is significant overlap between these fields. For example, studies in behavioral finance have demonstrated that investors as a group tend to overweight recent trends when predicting the future; a poorly-performing stock will remain bad, and a strong performer will remain strong. This lends credence to the contrarian's belief that investments may drop "too low" during periods of negative news, due to incorrect assumptions by other investors, regarding the long-term prospects for the company.