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Understanding Contrary Indicators

Saturday, May 31, 2008 | 09:25 AM

in Contrary Indicators | Economy | Markets | Psychology/Sentiment

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)

Sources:
The Conference Board Consumer Confidence Index Declines
May 27, 2008
http://www.conference-board.org/economics/ConsumerConfidence.cfm

When Consumers' Pain Is Investors' Joy
KOPIN TAN
Barron's THE TRADER, JUNE 2, 2008
http://online.barrons.com/article/SB121218729918634029.html

Consumer confidence: Worst since '92
Catherine Clifford
CNNMoney, May 27, 2008: 1:08 PM EDT
http://money.cnn.com/2008/05/27/news/economy/consumer_confidence/?postversion=2008052713