Understanding Contrary Indicators

Yesterday, I mentioned in passing a fabulous cover story from a 1962 Time magazine. While these sorts of contrary indicators are subject to interpretation, they are worthwhile to those who can properly interpret them, as they can provide insight that is not readily available elsewhere.

I have been tracking these sorts of signals for many years. In 2003, I published a research piece, titled Contrary Indicators 2000 – 2003 Bear Market. I thought it was important to remind people that, despite the fact the market had been shellacked, there were plenty of signs of a major bullish reversal that could be followed by tradrs, fund managers, and investors :   

"Astute observers of Human Nature have learned to detect the many “Contrary Indicators” on display throughout this crash. Traders who learn to use these contra-signals are better able to deploy capital, manage risk, and anticipate market reversals. 

Anyone who manages assets for a living can garner a tactical advantage by learning to properly identify and employ these Contrary Indicators: They can be used as timing signals as well as help determine an appropriate investment posture (i.e., aggressive or defensive); Even for the least technically minded, they have value as risk management tools." 

That these indicators exist for both bullish and bearish extremes points to their agnosticism. However, these are easily misinterpreted. In this week’s Barron’s The Trader column, Kopin Tan discusses a specific JP Morgan research piece, which misuses a sentiment indicator, the Conference Board Consumer Confidence readings:

"Some of you, of course, are miffed at how Wall Street is banking on your largesse even as they trade your pain. The Conference Board said last week that consumer confidence sank to the lowest in 16 years. Your confidence has been this morose or worse only five times since 1967, and each time the stock market has rallied soon after, with the Standard & Poor’s 500 index producing average returns of 15% six months later and 23% a year after, according to JPMorgan."

Unfortunately, consumer sentiment surveys are coincident, not leading, indicators. And while JP Morgan is correct that Consumer Confidence Index has only been as bad as it is presently 5 times before (the current reading is 57.2), in 3 of those 5 previous occasions, the index got considerably worse (Approximately: 1992 = 48, 1980 = 49, and 1975 = 44).

Even worse, each of those low index readings in the 40s took place AFTER a 12 month or longer recession or bear market had already ended. At this time, it is premature to declare the worst over for either the Consumer Sentiment Index or the economy.

Consider the 2003 low came after the 78% drop in the Nasdaq; the 1980 low came in year 14 year of a 16 year bear market; the 1975 low came after a horrific 1973-74 bear that saw the Dow Industrials get cut in half. Even the 1992 lows came long after the recession and market trouble in 1990.

Have a look at the chart below, via Joseph H. Ellis’ book, Ahead of the Curve. It shows that sentiment bottoms around the same time as the bear market. And, we have yet to get any where near the depths of of many of the 5 prior cycles.


Consumer Sentiment Surveys: Coincident, Not Leading, Indicators  

via Joseph Ellis
(note: this chart does not include 2008 data)


The Conference Board Consumer Confidence Index Declines
May 27, 2008   

When Consumers’ Pain Is Investors’ Joy
Barron’s THE TRADER, JUNE 2, 2008   

Consumer confidence: Worst since ’92
Catherine Clifford
CNNMoney, May 27, 2008: 1:08 PM EDT

Print Friendly, PDF & Email

What's been said:

Discussions found on the web:
  1. Scott commented on May 31

    Thanks — this is really excellent work. The Contrary Indicators PDF is a wonderful piece of writing.

    It just goes to show you, unless you do the research yourself, you really cannot trust what Wall Street or the Media publishes.

  2. Barry Ritholtz commented on May 31

    I appreciate the kind words, Scott.

    Although I am less harsh than you on Wall St / Media that look into these signals, you must do your own homework.

    To their credit, I was at a Wall St firm when I wrote that, and they had no problem with me publishing it as part of the firm’s research product.

    Barron’s is also very good for ferreting out intriguing data points, and while I disagree with JPM piece, at least someone is looking for statistical evidence . . .

  3. dblwyo commented on May 31

    Here, here. Here, here. For many reasons. Ellis’ work is something everybody should be familiar with and his online charts are a great starting point. Personally I’ve borrowed (stolen) a bunch form his approach and it’s been very valuable. He’s really the progenitor of the YoY meme that’s swept all the state reporting.
    Next that’s a greatly ironic post in that JPM’s last major analyst presentation absolutely contradicted it. It was by Dimon and you can find it on their web site under investor relations. The whole pitch is an insight into JPM, the industry, the credit crisis and the economic outlook.
    Another source of excellent historical context is BeYourOwnEconomist by Mike Lehman who just looked at confidence:
    That’s to the whole site because he also looked at Autos, Retail and Durable goods orders with some surprising and valuable insights. And not positive ones especially on capex.
    Which should then be paired with NoTrust’s recent discussions of corporate profits and outlooks – which are rather scary.

  4. rww commented on May 31

    you’re a beautiful man, BR. This is great work.

  5. Jagmohan Swain commented on May 31

    Ok time for some bullish talk:

    If you want to track the rate of national output Chicago purchasing manager’s index is a good start.It continues to hover close to 50, much closer to expansion phase than recession phase.So what’s keeping this index going.Let’s see:
    1: Exports are booming.That’s supporting production.
    2: Inventories are low, production is in step with sales.Hence dramatic cutback in production is simply not required.Considering that employment never rose dramatically at the expansion phase, scope for a huge reduction in labor force is not there either.So the negative feedback loop on production due to job losses is impotent this time around.
    3:Corporate borrowing costs (interest rates)
    are all time low and getting lower.That’s
    a great environment for starting new projects/ adding more productive capacity simply because of low cost of capital.

    If we had to see the worse we should have seen it by now.But it’s hard to see things getting worse from here instead of getting better.Why?

    1:Fed started cutting rates from sep 2007.We are in June 2008.The effect on rate cut we already beginning to see.Corporate bond issuance is picking up, commercial paper market spreads have narrowed.The yeild curve spread 3mo-10 yr is 2.10.That’s enough incentive for the banks to continue lending again.M2 is growing nicely.

    2:Stimulus checks will help us for next two quarters.

    3:Since February low we have added close to two trillion dollars of wealth to US stock holder.Enough to offset some 20% setback from housing market.Buying a house is getting attractive again vis-a-vis renting.Prices will continue to fall from
    inventory overhang but expect sales to pick up around 2009, if the mortgage rates remain the same.

    There are plenty of positives going on and sentiment being overwhelmingly bearish is serving as a wonderful cushion for the economy.

  6. Muckdog commented on May 31

    First, people are depressed because they can’t get a Nintendo Wii. Those things sell off the shelves within 30 seconds! Secondly, those who do have a Wii are now upset that they can’t find any Wii Fit games. And folks need the exercise, the obesity rate here in this impoverished country is extremely high.

  7. keith commented on Jun 2

    Ken Heebner has made my family a lot of money. He keeps very few stocks in the Focus fund which is a big advantage and he seems always to be heavy in the right sectors. Many of the mutual fund managers all tend to have the same stocks and with almost the same percentage allocations. He’s had bad quarters but I would not advise anyone to go contrarian for any length of time against his picks.

Posted Under