Sunday, February 17, 2013

Is the crowd always wrong?

A truism of contrarian investing is that the crowd is usually wrong at major turning points.  That is, small investors as a group tend to be wrongly bullish at tops and incorrectly bearish at bottoms.  For the most part this observation holds true, but there is an important exception to this.

The crowd actually tends to be on the right side of the trend starting around the middle of a long-term swing and continues on the right side of the trend until the trend terminates.  Countless examples could be offered of how the crowd “gets it right” during long-pull bull markets, such as the ones of the 1980s and 1990s.  Moreover, crowd participation in a major bull market is what gives the bull its impetus; without the crowd the trend would only go so far before reversing. 

As powerful as institutional traders are, they can’t create long-lasting trends without broad participation of millions of retail investors.  This is one of the reasons why the bull trends of the ‘80s and ‘90s were so powerful and long-lasting compared to the truncated and volatile bull moves of the last 10 years or so.  The public isn’t participating as much in the stock market today like it did in previous decades.

Writing in the latest issue of the Cabot Market Letter, Michael Cintolo observes: “While the crowd is ‘wrong’ at the very end of the trend, the crowd is actually ‘right’ in the weeks and months leading up to the turning point.  Contrary-minded investors who fail to understand this nuance often find themselves acting far too early, like the people who sold out of the market in 1997 when sentiment was deemed ‘too high’ (and thus missed out the final years of the great bull market) and those who bought into the market in the fall of 2008, thinking sentiment was as bad as it could get (and quickly had their heads handed to them).  In both cases, market trends proved to be longer lasting and more powerful than expected.”

So before you’re tempted to dismiss the market’s latest bull run by thinking the public is “too bullish” on stocks, consider that investor sentiment as measured by AAII hasn’t reached the vertiginous levels associated with previous major tops.  And don’t forget that the crowd (that is, those that actually have a stake in the market) might just be right…for now at least. 

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