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Contrarian Analysis by Gauging Investor Sentiment with the VIX - Mike Swanson (08/10/08)

Contrarian analysis. That's a big investment buzzword that gets thrown around a lot. You see most people are wrong at important market turning points. People have a tendency to get excited and buy at tops and then ride their positions all of the way down and sell them at the bottom.

Very few people have the discipline to sell their positions. In fact most investment advisors and brokers use the word "discipline" to advocate holding on while things fall on you.

They claim that "disciplined" investors invest in the stock market for the long-term and use "average cost buying" when their investments fall on them. Their theory is that the market will go up in the long-run so you need to buy, hold, and buy more and imagine that any losses you may have now are just temporary. They think contrarian analysis means not selling in a panic when others get scared. They think you need to be willing to tough out losses.

But that is exactly what you do not want to do. You see from 2000 to now the stock market has gone nowhere. Anyone being "disciplined" enough to ignore their losses and buy more no matter what has lost money and lots of it.

That's not being disciplined, that's being stupid. They aren't smart or being tough willed, but being totally neurotic.

But brokers and WallStreet make money by being in control of your money. If you sell you may move your money somewhere else and that is the last thing they want you to do. It is not so much that these people are conciously lying to you it is that they have rationalized all of their thoughts and thinking processes to align them with what is in their best interest. Most brokers and investment advisors believe the Wall Street propoganda themselves and really have no clue about how the stock market really works.

Of course you also have to understand that if you have a broker or investment advisor they are actually under a lot of pressure by you to stay bullish all of the time.

Here is the deal- if your broker thought the market was topping out and called you up and convinced you to sell your positions you would most likely get extremely angry at him if the market then went higher. You would think he is crazy and probably move your money elsewhere. But if the market drops you may get upset about the market, but you won't blame him for that. He'll tell you to stay disciplined and most people will do it - because when you get down to it most people would rather lose money by holding then face the possibility of making a decision and being wrong especially when everyone is telling them to keep holding on TV.

So the broker stands to lose everything by being negative on the market and being wrong and very little by being positive on the market when it is even in a bear market.

Wall Street has defined being "disciplined" as allowing them to control your money forever.

Real discipline is aligning your investment positions with reality. That means being bullish in bull markets and bearish in bear markets and correctly identifying the trend any stocks you may own are currently in and be willing to accept the fact that one day their trend will likely change and that is when you will want to take your profits - or cut your losses if you don't have any.

That is what discipline is really about.

And contrarian analysis is another buzzword that gets thrown around. People think it means buy low and sell high and sometimes it does.

But what it is really about is taking advantage of the fact that the masses are almost always wrong at important market turning points. People buy on tops and sell on bottoms.

When a market is in decline most people don't take action. They fail to recognize that the trend has changed on them or stubbornly think they are going to be "disciplined" and macho and just hold on in the face of losses, because they believe their positions will go up - because they have to.

The next thing you know their positions fall more and more and eventually they simply cannot take the losses anymore and sellout. They then admit the reality of the downtrend their stocks have been in and start to say that it is a bear market. The masses tend to do this together and that is why at real market bottoms almost everyone is bearish - but on the way down as they try to stay tough they convince themsevles that the market is still bullish.

Contarian analysis is about understanding investor sentiment and pinpointing these psychological turning points in the stock market.

It is more of an art than a science.

There are various investor sentiment surveys that are helpeful to find out when investors are overly bullish on the market and you should be worried or when they are so pessimistic that a market bottom is probably at hand.

I've found one of the most accurate sentiment tools when applying contrarian analysis by gauging sentiment to be the VIX indicator - The Chicago Board Options Exchange Volatility Index.

It trades the implied volatility of options for the S&P 500 index.

It measures the expected volatility options players are forecasting for the next 30 days.

This is important because at market bottoms some investors buy lots of put options as insurance on their positions instead of simply selling their positions.

This massive put buying drives the options volatility premiums higher and in turn makes the VIX rise.

Unlike most contarian analysis sentiment surveys the VIX trades in real time so you can see it move up or down as the market moves.

It is probably the most valuable single indicator I use to identify a market bottom.

You'll find in my writings on the market that I'll mention the VIX a lot during market corrections as I look for signs that a bottom is in.

Important bottoms have come when the VIX has gone above 30, but it has even gone to 40 and 50 a few times. You can see historical charts for it here:

Contarian Analysis: The VIX Chart

You can find more about the VIX at the CBOE website, it has several white papers that fully explain it for you also, including how it is caculated:

Contarian Analysis: VIX White Paper and Calculations from the COBE

BTW - their is now a VIX for gold stocks. It trades under the symbol GZV.

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-Mike Swanson