Markets Getting Over Bought / Over Bullish
One of my favorite quotes is by Howard Marks and is a principle that we live by in our little investment shop; "Resisting – and thereby achieving success as a contrarian – isn't easy. Things combine to make it difficult; including natural herd tendencies and the pain imposed by being out of step, since momentum invariably makes pro-cyclical actions look correct for a while. (That's why it's essential to remember that 'being too far ahead of your time is indistinguishable from being wrong.')
Given the uncertain nature of the future, and thus the difficulty of being confident your position is the right one – especially as price moves against you – it's challenging to be a lonely contrarian."
If you think about the basic philosophies of the "great investors of our time" you will find that their rules are primarily based on going against the "madness of crowds". Selling when everyone is buying, buying when everyone is selling and betting against the herd mentality has always been advice that investors are told to live by - yet, because of human nature, we tend to do just the opposite.
As Howard Marks stated the act of being a contrarian is a very lonely endeavor and plays against the nature of human emotion. When things are going well - we want them to continue to do well. We ignore the signs that something may be going wrong because we don't want to the "good times" to end. However, these are the very signs that we need to pay close attention to even as unpleasant as that may be.
If you think about bullish/bearish sentiment like a "gas tank" in an automobile you will understand the idea better. At the end of September the majority of investors were very "bearish" on equities which, from a contrarian viewpoint, was like a full tank of gas. As sentiment began to become less negative investors piled back into equities pushing the market higher. Normally, from the levels of negativity that we witnessed, the markets should have at least reached old market highs or potentially set new highs for 2011. Unfortunately, that was not the case. The market remained stuck in neutral, with the engine running, going nowhere while "burning up" the fuel in the tank.
Today, the level of weekly sentiment is beginning to approach levels of optimism that are normally witnessed near market tops. Which, as a contrarian, begins to make us more alert to the possibility of this cycle coming to an end. Our job as investors is simple - we all have pieces of paper to sell and our job is to "sell" them to some other "sucker" at the highest possible price. Remember that the stock market is based on the "greater fool" theory in that there is always someone there willing to pay a higher price. This is true until it isn't and you want to be the seller - not the "fool".
However, it isn't just this bullish/bearish composite sentiment index that is sending up a potential warning. Our weekly over bought/sold momentum indicator is confirming the same. The recent rally to "nowhere" has used up the "fuel" that was available very rapidly. With the indicator in over bought territory we may well be closer to the end of the current advance than the beginning.
Sell And Run Away?
At this juncture most individuals tend to let their emotions get the better of them and they make critical errors with their portfolios. Emotional buying and selling will always cause you to go against the basic contrarian investment views and leads to selling at the bottom and buying at the top. The point that we are making here is that you need to be aware that a) things do not go up forever and; b) they do not go down forever. The trick is understanding when things are getting to extremes which lead to a change in direction.
Being "contrarian" as an investor and going against the grain of the mainstream media feels like an abomination of nature. The halls of despair and broken portfolios are littered with the hollow cries of "what if I sell and the market continues to go up", or "if I sell at a loss I will lose money" and "I am a long term investor" . These are all emotional pleas to keep you from doing what is necessary to navigate volatile markets safely. Becoming a successful investor requires a strict diet of discipline and patience combined with proper planning and execution. Emotions have no place within your investment program and need to be checked at the door. Unfortunately, unless you are Spock, being emotionless about your money is a very difficult thing for most investors to accomplish. As humans we tend to extrapolate the success or failure within our portfolios as success and failure of ourselves as individuals. This is patently wrong. As investors we will likely lose more often than we win - the difference is limiting the losses and maximizing the winnings. This explains why there are so few really successful investors in the world.
However, with this in mind it doesn't mean that you can't do well as an investor. It is ever more important that you pay attention to the "risks" inherent in the market and act accordingly. Generally, the process of acting accordingly requires nothing more than just dong the opposite of what everyone else is doing when the markets began to reach extremes. While bullish sentiment has yet to reach extremes other indicators that we monitor on a weekly basis have. This doesn't mean that you need to act immediately, however, it does mean that the "tank" in the car is getting close to empty. After the next correction, which will come in time, the "fuel" will be replenished and another attempt will be made. The difference between success and failure will be determined by the amount of damage the correction does to your portfolio.
If you were Howard Marks what would you be doing?