The Art of Contrary Thinking in Markets

There’s a saying in markets that we should be friends with the trend (AKA the trend is your friend), which is true to some extent, because this means thinking like the masses, and this isn’t always the most profitable approach.

The importance of identifying a trend is to know the direction the market is heading and being able to trade accordingly. That is, if it’s bullish, we should focus on trading long. Conversely, a bearish market indicates that every rebound is an opportunity to short.

But market mass behaviour is peculiar, and that is, at trend reversal points, the masses tend to be wrong. Let’s delve into what this means.

Market tops often occur when optimism reaches an extreme level, and conversely, market bottoms are formed amid the deepest pessimism. And in both cases, the majority of investors (the masses) are mistaken and pay for their error by being long at the end of a bull market/beginning of a bear market and short or with no position at the end of a bear market/beginning of a bull market.

Now, as we mentioned in the introduction of the article, we should be friends with the trend but knowing that it will come to an end at some point. This is where we need to differentiate ourselves from mass thinking and be bold enough to consider selling or buying when the market and the news tell us otherwise, even when our own friends may think we’re crazy.

This not only applies to trend reversals but also to certain market-affecting events, which are often binary, such as a presidential election, earnings reports, or the announcement of a new product. Here, we need to consider some additional aspects such as psychology and experience.

Let’s see an example. Suppose there’s a presidential election where one candidate is left-wing and the other is right-wing, and the market clearly prefers the latter. Consequently, it positions itself long because it believes the right-wing candidate will win by a wide margin. Here, there are two issues. First, going against what the rest of the participants think and do can be very profitable if the election doesn’t turn out as expected (we’d short, and the market would decline because all the longs would sell their positions in panic over the adverse outcome). 

But even if the right-wing candidate wins, as the market expects, if everyone is already long, then who will buy to push the market higher? Well, no one, which will result in no significant rise and possibly even a decline. 

The first is an example of the 2019 Argentine election, known as “Lunes Negro”, with a 60% drop in the local stock market, the largest drop in its history and one of the top 3 drops in world history. Being a contrarian pays off, doesn’t it?

Another example is earnings reports, particularly that of $NVDA this week, where the stock has been rising non-stop for months, and the market approached earnings day with too much fear that things would go wrong. In fact, it was taken for granted that it would be bad and would drag the entire market down (it fell by 10% in the days leading up to it). The result? It beat all estimates and rose by 14% in pre-market trading.

The market always punishes consensus simply because there’s no one left on the other side. As Livermore said, ‘There’s only one side of the market, and it’s not the bullish or bearish side but the right side’.

As you can see, having a contrarian mindset often pays off in the market, but we mustn’t fall into the trap of being contrarians just for the sake of it, as going against a clear trend can leave us out of the game. 

Therefore, critical thinking, analysis, and experience are usually crucial when honing this aspect that will bring us many satisfactions.  

This article was partly based on the reading of the book “The Art of Contrary Thinking” by Humphrey B. Neill, a must in your market library!