A Contrarian Approach to Investing

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Despite the recent good economic reports, sentiment remains bearish and the stock markets are staying down. As I have mentioned before the FTSE 100 is the leading index and the S&P 500 is now catching up with the FTSE 100. Companies listed on the FTSE 100 are exposed to emerging markets which are a barometer of the global economy and include major market-moving sectors like mining, oil and banks. When the FTSE turns down, it’s time to be fearful.

I also said a few months ago that the FTSE is forming a major top. The extreme in bullish sentiment recorded in April and May this year was the first signal of an impending top. How can you tell when the market is reaching the top? Simply by looking at the Investors Chronicle covers. The first cover below titled “Return of the bull” was published on 15th March 2013:

When the stock market has had a good run and public interest is so high that it’s casually discussed over drinks, this can be viewed as a negative. Likewise when the bullish story appears on the front cover of a major investment publication, we shall turn bearish. The message “prepare for the coming equities boom” should be interpreted as “prepare for the next bear market”. The above magazine cover has given a good sell signal. On the day it was published the FTSE 100 closed at 6489, fast forward one month and the FTSE 100 was down 4% with the low of 6225 recorded on 17th April.

From there the index rallied until 22nd May from 6225 to 6875, this extraordinary run up created a second wave of extreme optimism and a few days later on 24th May a second bullish magazine cover was published:

The cover-page article is summarised in the following sentence “You don’t need to know more than other investors to beat the market. Instead, you need to start taking on risk”. For a contrary signal, the timing of the article could not have been more precise; the FTSE 100 declined 9.4% over the next four weeks.  Note the unmistakable change of tone which is decidedly more aggressive, in April the message was to be invested in the stock market, but in this article investors are blindly told to take on more risk. Unfortunately any investors who took this advice would have lost a lot of money as the message came at the start of a massive decline. To the astute investors out there, this magazine cover story once again offered an excellent contrary sell signal.

With the FTSE currently trading near 6500 and well below the high set in May this year, it appears that both magazine covers gave accurate warning signals to those who are paying attention to sentiment. Sentiment analysis is a powerful tools and I will have more to say on the subject at the next meeting of the Society of Technical Analysts on 10th December where I will discuss the effect of sentiment on stock prices.

Meanwhile good economic reports means the fear of tapering has returned. If the nonfarm payrolls report out on Friday is strong, then the stock market decline could accelerate. We are in a weird world where good news is bad news – I say weird because this is not usually how the stock market works! There’s an army of fundamental analysts who like to buy when the news is good, so in theory the FTSE should be rising, not falling. What will they do when the news is bad and QE continues? They are not going to buy bad news surely?  The Fed has indicated that QE cannot go on forever, there will be a time when the music will stop and market participants will stop dancing. This moment is fast approaching.

Right now sentiment is bearish. Like on 15th March and 24th May my sentiment indicator gave me a signal to go neutral on 26th November. I therefore locked in my profits and protected my portfolio in anticipation of a potential move lower. And my call was right as since then the FTSE is down more than 100 points.

The FTSE is now trading around the 6500 level, the decline has been noteworthy considering that the S&P is not far from its all-time high. The difference between the two indexes is that the S&P is still in the early stages of the decline but the FTSE decline is more developed. Perhaps the FTSE will start to outperform the S&P in which case there is not much downside potential left. And if sentiment turns positive we can look forward to a Santa rally.

Thierry Laduguie is Market Strategist at www.bettertrader.co.uk

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