Synopsis:
Successful investors and stock traders face many challenges. One of the biggest challenges is that to outperform the market as a whole, you can’t just go along with what everyone else is buying and selling.
It can be extremely scary and difficult to do the opposite of what the herd is doing, but many times it’s the most profitable call. Here’s a look at what traders need to know about contrarian indicators.
What Is a Contrarian Indicator?
A contrarian indicator is a form of market indicator that tells a trader it might be a good time to do the opposite of what the majority of investors are doing. For example, a contrarian indicator may tell a trader to buy a stock in the middle of a sell-off.
It may seem counterintuitive to do the opposite of what everyone else is doing, but healthy markets typically go through cycles of bullishness and bearishness. If you consider the old Wall Street adage “buy low and sell high,” contrarian investing makes sense. To buy low, you must be buying at a time that everyone else has sold. Then to sell high, you cash out of your trade after everyone else has bought the stock.
Investor Sentiment
Perhaps the most popular contrarian stock trading indicator is investor sentiment. Investor sentiment is a measure of how optimistic or pessimistic other investors are feeling. Overly bullish investor sentiment is often considered to be a bearish contrarian indicator. In other words, when everyone else is most optimistic, it’s often a good time to sell.
For example, it seems obvious in hindsight that the worst possible time to buy a stock is during a market bubble. However, general excitement and hype surrounding a stock always peak during a bubble. When every trader out there believes they are getting rich from a stock, it’s probably a bad sign.
You can find plenty of ways to track investor sentiment. Traders can gauge investor sentiment by looking at weekly mutual fund money flows. The American Association of Individual Investors also publishes weekly investor sentiment survey results. StockTwits includes sentiment data for stocks and ETFs that measures how bullish or bearish posters are on each ticker.
Analyst Ratings and Targets
Another popular contrarian indicator is analyst ratings. When a stock’s price action doesn’t align well with its analyst ratings and price targets, analysts typically react by adjusting their outlooks with upgrades or downgrades or changes to their targets.
When a stock’s price has dropped significantly in a few weeks or months, bullish analyst ratings can be a bearish contrarian indicator. If an analyst has a “buy” rating and $100 price target on a stock that subsequently drops 40% and is trading at under $50, that analyst may react by downgrading the stock to “hold” and cutting the price target to $60. An analyst downgrade and 40% price target cut typically function as a negative catalyst.
At the same time, a stock with a high percentage of analyst “sell” or “neutral” ratings that has outperformed could be set up for potential upgrades or target hikes. In that situation, the relatively bearish analyst opinions could be a contrarian indicator to buy the stock.
Takeaway
Your parents may have told you at a young age that just because everyone else is doing something doesn’t make it right. On Wall Street, chasing the herd is typically a good way to lose money.
Instead, watching for extremes in contrarian indicators such as investor sentiment, analyst opinions and mutual fund money flows can be a great way for traders to stay a step ahead of the next move in the market.
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