Many analysts rely on contrarian investment rules to determine their market entry and exit points. Contrarian rules are founded on the premise that the majority of investors are wrong as the market approaches peaks and troughs. Contrarians try to determine when the majority of investors are either bearish or bullish and then trade in the opposite direction. The model discussed here helps to identify contrarian entry and exit points.
Methodology
Contrarian investors generally believe that stock market participants are wrong at peaks and troughs. Thus, they believe that they should increase their positions in equities near a market trough – to take advantage of an expected market rise. At a market peak, contrarians expect the market to be fully invested in equities with a low percentage in bonds and, consequently, sell stocks and take profits. Stated differently, contrarian investors watch for the stock market cycle and/or the business cycle to approach one of the extremes and act contrarily – gradually increasing positions in equities near bottoms and decreasing positions in equities near tops.
Economists and contrarian investors use various measures to judge the state of the business/market cycle. Our business cycle and market cycle measures provide insights into the output gap of the economy and the fair-value gap of the stock market and were developed using the Hodrick-Prescott filter, a mathematical tool used to remove the cyclical component of a time series from raw data. The filter was popularized in the field of economics in the 1990s by economists Robert Hodrick and Nobel Memorial Prize winner Edward Prescott. The mathematics underlying the formula are quite complex but can be found in any advanced statistics/econometrics book.
Trading strategy
The interpretation of the indicators is summarized below. Specifically, a market cycle (fair-value gap) of +100 is considered light speculative trading and the beginning of an overbought market while +150 signals high speculative trading and an overbought market. Investors are well advised to reduce their positions in equities at these times. A reading of +200 is considered heavy speculative trading and a highly overbought market. Note that as the market cycle unfolds, investors should hold an accumulate (or buy or strong buy) position until a reduce (or sell or strong sell) position is triggered. Likewise, an investor should hold a reduce position (or sell or strong sell) position until an accumulate (or buy or strong buy) position is triggered. This helps to ensure investors that they are always buying low and selling high.
Contrarians who prefer to take their signals from the business cycle rather than the stock market cycle should accumulate equity positions when the business cycle (output gap) rating dips below -150, with buy and strong buy recommendations triggered at -200 and -250. It's important to note that the fair-value gap typically peaks in advance of the business cycle gap as it is a leading indicator of economic activity.
Summary trading strategy
U.S. Standard & Poor's 500 Findings
Figure 1: Contrarian Model, 2012-2016
Interpretation
Our contrarian model has produced good results. The system accurately predicted buy and sell activities in the market runup of the 1990s, based on both the business cycle output gap and the market cycle fair-value gap, giving investors solid and safe returns. It also identified well timed contrarian buy signals in late 2001 and early 2002 following a -100 breach in the market cycle gap and a -150 breach in the business cycle gap. Investors buying in 2002 and holding until the next contrarian reduce and sell signals would have earned exceptional returns. Contrarian buy signals triggered in 2008 and 2009 were also well timed. Our market cycle fair-value gap signaled reduce in early 2011 with a re-entry point triggered in late 2011. Currently, the system is signaling "HOLD" based on only a slightly negative fair-value gap and a slightly negative output gap.
Canada S&P/TSX Findings
Figure 2: Contrarian Model, 2012-2016
Interpretation
Our contrarian model has produced good results. The system accurately predicted buy and sell activities in the market runup of the 1990s, based on both the business cycle output gap and the market cycle fair-value gap, giving investors solid and safe returns. It also clearly identified contrarian sell points in 2007, prior to the market collapse. Strong contrarian buy signals were triggered in 2008 following a -250 breach in the market cycle gap and a -250 breach in the business cycle gap. Investors buying in 2008 and holding until the next contrarian reduce and sell signals would have earned exceptional returns. Contrarian sell signals in 2011 based on both the business cycle gap and fair-value gap were also very well timed. Currently, the system is signaling "HOLD" based on the business cycle gap and "ACCUMULATE" based on the fair-value gap.
Stay tuned.
Next week we will be discussing the "Buffett Model," the eighth of our nine market timing indicators.
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