|Human reason is such a powerful tool that even our blunders are intelligent.
The Freudian slip, which is among the most abundant species of human error, typically contains more information than the statement it mistakenly replaces. What Jimmy Carter meant to say at the 1980 Democratic Convention was the name of the next speaker, Hubert Horatio Humphrey. What he actually said, given that we already knew the gentleman's name, was vastly more thought-provoking: "...my good friend and a great American, Hubert Horatio Hornblower."
Some mistakes are even more potent. Loose lips, we've been warned, sink ships. Of more practical significance, cognitive psychologists have identified the most characteristic form of human confusion, which is also the most elegant; namely, that we tend to do precisely the wrong thing or to perceive the exact reverse of the truth. The most frequent angle of misperception is 180 degrees.
Now that takes talent. It also promises invaluable guidance for people who wish to learn from the mistakes of others rather than their own. For investors, it supplies one of the keys to sensing the warp and woof of a market: the contrary indicator.
It took the smart-money crowd awhile to figure this out. Not one of the towering geniuses of economics or finance could find a way to make reliable predictions of what the stock market would do next. And yet, toiling for decades in private oblivion, thousands of poor, benighted amateurs were able to foresee the market's every gyration with perfect clarity -- though, as it happens, upside down.
What the major market analysts finally realized was that there were people out there who invariably did exactly the wrong thing. It's as if no scientist had ever been able to develop a compass that would point north, but some bumbling amateur had managed to make an instrument so defective that it pointed unfailingly to the South Pole.
For stock market technicians, just such an inverted divining rod emerged in the hands of the odd-lot short seller, possibly the most cherished and least respected financial mind in the long history of going short.
The odd-lotter, the impecunious small investor unable to buy round lots of 100 shares, is presumed to be not only under-capitalized but also under-informed, ill advised, panic-prone, and non-logical.
When these chronic bunglers sell short in great numbers, staking their meager assets on a decline in the market, sophisticated investors smile knowingly and proceed to buy with a vengeance. (I'm using the word "sophisticated" here the way it is used by Wall Street advisors: if you are rich, and if I make my living by advising the rich, then I'll probably call you sophisticated. You, in turn, will prove me correct by hiring so perceptive an advisor. This is the kind of logic that utterly escapes the odd-lot short seller.)
How well does this contrary indicator work? When big investors see the odd-lotters selling short and they plunge into the market with billions of dollars, sure enough the market rises. It works splendidly.
They may, it's true, be confusing cause with effect, but that's just another illustration of the power of reasoning in reverse.
There are other contrary indicators, each relying on the exactly-backwards tendency of mental and emotional processes gone awry. In markets driven by fear and greed, it's all too easy to get caught off base, being afraid when you should be greedy or greedy when you should be afraid.
For the small investor, there is the additional problem of paranoia. And, as Charles Osgood once pointed out, "Just because you're paranoid doesn't mean they're not out to get you." If we contrary indicators have the feeling we're being watched, it may be because we're being watched.
It wouldn't surprise me to learn that when I go short on thirty shares of Broken hill Proprietary mines, phones start ringing up and down Wall Street; that the word goes out, amid gales of laughter: "Van Dine thinks precious metals are heading south." Suddenly, mutual funds and pension funds are pouring their money into precious metals stocks, which of course drives up the prices and scuttles my short sale -- and behold, those masters of the self-fulfilling prophesy are right again! As noted by the once-prestigious firm of Simon & Garfunkle, "No matter how you look at this, you lose."
So the lot of a contrary indicator is an odd, unhappy one. The odd-lotter finds himself irrevocably appointed as the laboratory rat of Wall Street, condemned in perpetuity to choose the electric shock instead of the cheese.
His dilemma is twofold. (Aren't they all? That's why dilemmas have horns.) First, there is the problem of keeping one's ego intact in the face of being everlastingly wrong. Second, the only escape from this maze is to migrate to the ranks of large investors, which is extremely difficult to do when your every get-rich scheme culminates in catastrophe.
Revenge of the Little People
There are compensations, of course, one of which is the tremendous power we small investors wield. Without our wrong-headed plunges to show them the (opposite) way, the big institutional money managers would be helpless. Sometimes, just for the sport of it, we stay out of the market for months on end and watch it slide this way and that, rudderless, while once-decisive analysts write plaintive articles in Barron's, praying aloud for the return of the individual investor.
Beyond such mischievous pranks, we've nursed some hope in recent years for a counter-offensive, using some of the same tactics to which we've so often fallen victim.
Our ultimate weapon would be the Theory of Contrary Opinion, first popularized in the early 1950's by the Vermont Ruminator, which may sound like a dairy cow but was actually the nom de plume of Humphrey B. Neill. While the giants of Wall Street had been watching us lemmings, Neill had been watching them, and he noticed that every time the major analysts and portfolio managers achieved widespread consensus on the direction of the market, the market itself promptly swung to the other extreme.
Well, of course. Once everyone with major money is agreed that stocks will continue to rise, then everyone is fully invested and many are fully margined. No one has much money left to commit, so the market has nowhere to go but down. "When everyone agrees," wrote Neill, "then everyone is likely to be wrong."
The Cockeyed Consensus
He illustrated the point with an SEC survey, taken after a horrendous market slide in September of 1946. The Commission looked through the written recommendations sent out by broker-dealers and investment advisors during the week preceding the crash. There were 257 bullish opinions, while only 20 of the experts had advised their clients to sell at least some of their shares. Roughly the same pattern repeated prior to the crash in 1987 and again in late 2000.
Once the would-be contrarian catches this scent, the evidence mounts up quickly. After each of the World Wars, most economists forecast an inevitable depression, with defense industries collapsing and millions of returning servicemen searching for nonexistent jobs. In each case, the actual economy boomed. Once this phenomenon is recognized and given a name (the post boom-boom boom), it will come to be regarded as an economic law and will no longer work.
What sets the stage for the contrarian is that rising markets often breed euphoria and speculative excess. The return to earth is inevitable, and it is seldom gentle.
In his book Manias, Panics, and Crashes, Charles Kindleberger recites the sorry history of investor hysteria in everything from Dutch tulips to Welsh copper and the periodic fevers in gold, real estate, the stock market, and commodity futures of every sort. In retrospect, it's easy to see that every bubble finally bursts; but in the heat of speculation, with fortunes being made overnight, crowd psychology takes over and everyone gets into the act including the experts. Even for the Alan Greenspans of this world, it's hard to remain calm the day the cleaning lady buys her yacht.
Marching to Euphoria
In the early 18th century, an investing mania broke out in England which would later be known as the South Sea Bubble. It was a pyramid scheme promising untold riches in trade with the South Sea Islands and South America, which loomed very large but at that time traded very little, and only with the Spanish. Robert Walpole, who knew enough about finance to have served as first lord of the treasury and chancellor of the exchequer, immediately denounced the whole scheme in Parliament as utterly unsound and doomed to ruin. But when the South Seas Trading Company finally collapsed, Walpole was one of the many sophisticated investors who had ultimately succumbed to the fever and lost heavily when the walls came tumbling down.
The modern American equivalent, the great speculative booms of the late twenties and late nineties, produced a similar stampede and, again, most of the wizards and seers eventually joined the mob. On the eve of the great 1929 crash, eminent bankers, economists, and financiers were busy describing a new age of permanent prosperity with riches for one and all.
At the other extreme, extended slumps breed a deepening pessimism until most experts agree that no relief is in sight. In midsummer of 1982, with the Dow Jones average under 800, there was hardly a "buy" signal to be heard in the land. (True, there are many financial newsletter writers who still claim to have called every major turn of the market in recent years. With two or three exceptions, they must have confided that call to a close associate, like the one in the bathroom mirror.) Some analysts were calling for a further plunge of 150 to 200 points on the Dow. Abruptly, the market jolted to life as if someone had turned on the ski lift (someone had -- Paul Volcker, with a huge infusion of money supply and easing of interest rates), and the contrarians had all the good seats.
The Great Mavericks
Aside from its resonance with common sense, contrarian investing also has its pantheon of folk heroes. Bernard Baruch eluded the crash of '29. John Templeton made his fortune by borrowing $10,000 in the pit of the Great Depression and buying shares in every unloved blue chip whose jilted stock was trading at less than a dollar.
J. Paul Getty, in the book he deftly titled, How to be Rich, put it this way: "Buy when everyone else is selling, and hold until everyone else is buying." And Russel Sage, asked how he made his millions, replied, "by buying straw hats in January."
Armed with this cunning contrarian strategy, the investor need only acquire the knack of knowing when to disagree and with whom. If that part were easy, as Vic Braden would say, we'd all be famous by Friday.
It's not enough to watch Wall Street Week and do the reverse of everything they suggest. It takes patience, but the trick is to wait until an overwhelming majority of experts are thinking alike. If you plan to go against the crowd, you have to wait until the crowd forms.
Richard Band, once the contrarian editor of Personal Finance, said he held back until the "bullish consensus" of stock market advisors got above 75% to 80% or below 20% to 25%. If the advisors were 80% bearish for several weeks, Band considered the market a screaming buy.
When large illustrations of bulls show up on the covers of magazines like Time, Newsweek, Fortune, Business Week, and Barron's -- usually with a headline such as "The Raging Bull" -- consensus is complete and the sudden demise of the bull is imminent.
In May of 1984, Business Week's cover asked, "Are Utilities Obsolete?" and Barron's challenged, "Do Utilities Have a Future?" Within a week, utility stocks began a dramatic, multi-year climb.
Here, then, is the side door to the promised land. Wait and watch. As soon as the major players have achieved something resembling unanimity, the odd-lotter knows a spectacular reversal of the market is likely to unfold and make fools of them all.
Now the mighty will have to take their turn as lowly contrary indicators, while the lab-rats take over the lab.
"If Instead of Apes
We Had Come from Grapes"
is a book of light verse
written and illustrated
by Alan Van Dine