The Art of Contrarian Trading

Chapter 11).

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How will your media diary do all this? How will it enable you to acquire the emotional balance needed for the high-wire performance of contrarian trading? The answer is surprising simple: Your media diary will objectify the emotional content of media messages and market movements by freezing them in time. In this way they can be reexamined when the immediate emotional stresses of the moment have pa.s.sed. By doing this you will be able to see clearly the correlations between the content of the media when a crowd is enthusiastic and subsequent market performance. These historical observations based on firsthand, real-time recording of media content will develop your ability to identify the emotional extremes of crowd behavior and strengthen your willingness to invest opposite the crowd"s theme at such times. The media content preserved in your diary will help you remember how you felt felt at the time. Only by learning how the media make you at the time. Only by learning how the media make you feel feel when a contrarian investment opportunity is at hand can you learn to act contrary to the media messages that urge the crowd onward to its doom and disintegration. when a contrarian investment opportunity is at hand can you learn to act contrary to the media messages that urge the crowd onward to its doom and disintegration.

Your media diary will play another essential role as well. It will be your princ.i.p.al tool for identifying investment themes and the a.s.sociated investment crowds. Your media diary will record the media messages that play a central role in motivating investment crowds. These messages are the princ.i.p.al means of communication among investment crowd members. Media content is the driving engine of information cascades. By studying this content and comparing it to a.n.a.logous historical situations, you will be able to a.s.sess just where an investment crowd stands in its life cycle. These deductions in turn will help you implement "The Grand Strategy of Contrarian Trading" (see Chapter 11).

I have kept a media diary for more than 20 years. It has proved itself invaluable for identifying investment crowds. It has time and again helped me select the right moment to take a contrarian stance in the market. It has taught me to have confidence in my own judgment and to resist the seductive call of investment crowds. My diary is my single most important contrarian tool. If you want to become a contrarian trader, you must start your media diary now. In this chapter I explain how I maintain my media diary and what material goes into it. This is the most important chapter of this book.

HOW MY DIARY MADE A DIFFERENCE IN 2002.

Before we get into the details of building and maintaining a media diary, I"d like to tell you a true story that underlines the value of such a diary, even for a novice trader. This story shows what a valuable educational tool your media diary can be.

Back in March 2000 the stock market had reached the peak of the 1994-2000 bubble. The S&P 500 traded as high as 1,553 and eventually dropped almost 50 percent to a low at 768 in October 2002. The home of the dot-com and telecommunication stocks, the NASDAQ Composite index, reached a high of 5,132 in March 2000 and dropped almost 80 percent to a low of 1,108 in October 2002.

In January 2000 it was obvious to me and to many others that a stock market bubble had inflated. The only question was how big a mistake the market would make before the bubble popped. This is just about the hardest judgment any contrarian trader has to make. If you get it wrong, the damage to your net worth can be serious. I knew that the typical bull market in the stock market averages lasts about two years. The preceding bear market low had occurred in October 1998 with the S&P at 923. Combining these two facts, I guessed that the bubble would continue to inflate until roughly October 2000.

Over a three-week period from March 24 to April 17, 2000, the S&P dropped about 14 percent, from 1,553 to 1,333. The NASDAQ Composite dropped a stomach-churning 25 percent during the same three weeks. Since I expected the market to move above the 1,553 level later in the year, this seemed to me an opportunity to put cash reserves to work with the prospect of earning 15 percent over the subsequent six months.

My media diary emphasized this opportunity, too. On Sat.u.r.day, April 15, the New York Times New York Times ran its page 1 headline: "Stock Market in Steep Drop as Worried Investors Flee; Nasdaq Has Its Worst Week." The same day our local paper, the ran its page 1 headline: "Stock Market in Steep Drop as Worried Investors Flee; Nasdaq Has Its Worst Week." The same day our local paper, the Morristown Daily Record Morristown Daily Record, headlined: "Wall Street Wreck." I should say that both averages reached their low points early Monday morning, April 17, and continued upward for four and a half months. The S&P did not make a new high but did rally to 1,530 by August 31. A week later I was telling my clients to sell in antic.i.p.ation of a drop below 1,300.

Anyhow, although I am the investment strategist in our family, I always consult my wife before we change the allocation in our retirement portfolios. In this particular instance we were having dinner with our three children at a local pizza place on Friday, April 14. Over pizza I suggested to her that we put cash to work in the stock market because the severe drop of the past three weeks had presented an unusual opportunity. But she felt very uncomfortable about doing this, citing the severity of the drop; she suggested a wait-and-see stance instead. I knew that this was tantamount to pa.s.sing up the opportunity entirely, but for various reasons I chose not to argue the issue.

A few weeks later my wife and I were discussing this lost opportunity. She explained that the headlines at the time were very scary and made it hard to act, so I took her down to my office and showed her my media diary. We looked at the two headlines cited earlier, which I had clipped out and pasted into my diary. Then I reviewed with her the previous five or six buying opportunities in the stock market and showed her the headlines and other media content that appeared as the buying opportunities presented themselves. Of course in every case the time to buy was when the headlines were scariest.

Fast-forward to late July 2002. The S&P 500 index had that month dropped to its lowest level in more than four years. Alan Greenspan, chairman of the Federal Reserve, blamed a corporate culture blighted by "infectious greed" for the breakdown in investor confidence. On NBC"s Tonight Show Tonight Show Jay Leno regaled his audience with jokes about crashing stock prices and a swooning economy. Jay Leno regaled his audience with jokes about crashing stock prices and a swooning economy.

The July 29 issue of Time Time magazine had a cover story asking: "Will You magazine had a cover story asking: "Will You Ever Ever Be Able to Be Able to Retire Retire?-With Stocks Plummeting Stocks Plummeting and Corporations in Disarray, Americans" Financial Futures Are in Peril." (Emphasis is in the original.) and Corporations in Disarray, Americans" Financial Futures Are in Peril." (Emphasis is in the original.) For the previous week"s issue of Barron"s Barron"s Ben Stein and Phil Demuth wrote an article ent.i.tled "A Long Way Down." They predicted that stock prices still had a long way to fall because corporate earnings statements could not be believed. Ben Stein and Phil Demuth wrote an article ent.i.tled "A Long Way Down." They predicted that stock prices still had a long way to fall because corporate earnings statements could not be believed.

On July 20 I was up at 6:30 in the morning and opened our front door to retrieve the Sat.u.r.day editions of the New York Times New York Times and the and the Chicago Tribune Chicago Tribune. I was spreading the newspapers out on our breakfast table when my wife walked into our kitchen. We sat down together, me with my coffee and her with a bowl of Special K. I like to start with the New York Times New York Times but she prefers to read the but she prefers to read the Chicago Tribune Chicago Tribune first. first.

Here was the New York Times New York Times headline that morning: "Market Continues Four-Month Rout; Dow Plunges 390." The headline of a story by Floyd Norris right next to this headline read: "Adding to Loss of Investments, a Loss of Faith." headline that morning: "Market Continues Four-Month Rout; Dow Plunges 390." The headline of a story by Floyd Norris right next to this headline read: "Adding to Loss of Investments, a Loss of Faith."

"Yikes!" I thought. My wife read the Tribune Tribune headline to me: "Dow Dives to a Four-Year Low. Sell-Off Deepens: People Are Really Feeling Pain Now." headline to me: "Dow Dives to a Four-Year Low. Sell-Off Deepens: People Are Really Feeling Pain Now."

We were both silent for a minute or so. She was obviously digesting the headlines and I wondered how she would react. Finally she looked across the table at me and said, "I guess it"s time to buy?"

"Yes," I replied.

On Monday morning, July 22, we bought index funds for our retirement accounts with the Dow at 8,019 and the S&P 500 at 846. During the subsequent five years these averages advanced more that 75 percent from our purchase price.

Here was a situation in which a complete novice was able to make a very shrewd investment decision. My wife had observed firsthand in my media diary the correlation between scary market headlines and buying opportunities. From this she was able to draw the obvious and correct conclusion. Without a media diary that faithfully captured the emotional state of the crowd and preserved it for future examination, this sort of learning experience would not have been possible.

GET READY TO CUT AND PASTE.

To start your media diary, the first thing to do is buy some five-subject spiral notebooks plus some manila folders to use for keeping files of multipage stories and magazine covers. You will also need a good pair of scissors and lots of Scotch tape. Take one of the notebooks and put a t.i.tle on the front cover; I like to write Diary Diary together with the date of the first entry. When the notebook has been filled up, I add the date of the last entry to the cover and then put the entire notebook on my bookshelf for future reference alongside my older diary notebooks. together with the date of the first entry. When the notebook has been filled up, I add the date of the last entry to the cover and then put the entire notebook on my bookshelf for future reference alongside my older diary notebooks.

What sort of media content deserves to be preserved in your media diary? The answer to this question is simple, but perhaps a little surprising. Remember that market movements always generate news stories that encourage the belief that prices will continue to move in the same direction. People want explanations for market events, and this demand for explanation is something the news media strive to satisfy. Therefore, you want to look for stories reinforcing the optimistic or pessimistic moods that arise from rising or falling a.s.set prices. These are the stories that will reinforce the beliefs of the investment crowds you have identified. The most important of these are the ones that directly convey some obvious emotion (i.e., push the emotional b.u.t.tons of some investment crowd). Such stories might promote fear or optimism; it doesn"t matter which. These displays of emotion generally show up in emotionally tinged words or expressions, or descriptions of investor behavior. Pictures often can be used as emotional messengers, so don"t forget to watch for them, too.

We"ll see that when enough such stories appear in a relatively short interval of time, especially if they are likely to trigger emotional responses from investors, the trend that the story seems to encourage will instead probably reverse. You will princ.i.p.ally be interested in media content likely to catch the attention of the casual reader, people who, like yourself, are pressed for time and can"t examine stories in any detail. It is the casual reader who is most likely to be affected by the emotional tone of media content. Moreover, it is the casual reader whom news editors want to attract to boost sales. The things that attract the attention of casual readers are headlines, story headers, and magazine covers. When I find a story that has such a headline or header, I might read the first two or three paragraphs to try to gauge its emotional tone, but rarely will I read more than that.

Be especially alert for stories that editors think are important enough to put on a newspaper"s front page or that are otherwise highlighted by their position in the paper or by the emotional content of their header or of a picture appearing with the story. As a general rule, a prominent placement on the front page signals two things: First, the editors think their readers will find the story of great interest, and this gives you a read on just where the editors think the crowd"s attention is currently focused. Second, the prominent placement attracts the attention of more people, and thus is a more powerful reinforcement of the crowd"s mood and beliefs. Here I should add that the editorial page can also be a very good source of material for your media diary. Most newspapers rarely comment on market movements in editorials, so when they do you can be pretty sure that an investment crowd is on the verge of disintegration. The articles that appear on op-ed pages can also be valuable in this regard.

You will want to be as systematic as possible in checking for market-related stories in all the sources I cited in the preceding chapter. Here is my own daily routine for surveying media content.

I start each morning by taking a look at the New York Times New York Times and the and the Chicago Tribune Chicago Tribune over breakfast. I am princ.i.p.ally interested in stories that appear on the front page of either newspaper, but sometimes there will be a story on the front page of the business section or even a story inside the paper somewhere that attracts my interest. When I find such a story, I make sure to tear out those pages and add them to my stack of articles to paste into my spiral notebook. over breakfast. I am princ.i.p.ally interested in stories that appear on the front page of either newspaper, but sometimes there will be a story on the front page of the business section or even a story inside the paper somewhere that attracts my interest. When I find such a story, I make sure to tear out those pages and add them to my stack of articles to paste into my spiral notebook.

I"ll clip any story that is likely to catch the casual reader"s attention because of its headline or header, or even because of a picture that appears along with the story. The story"s subject is usually some aspect of the economy, business, or the behavior of the stock, bond, or commodity markets. But sometimes you will find a story that focuses on an investment crowd you have identified, explains its motivations, and gives an indication of its emotional state. I put this sort of story in my diary, too. I want to emphasize once more that that you are looking for media content that tends to reinforce the beliefs of the investment crowds you are following. Your goal is to be able to efficiently separate the content that will play an important role in reflecting and reinforcing crowd beliefs from the content that is just part of the daily and weekly media noise the financial markets generate.

I"d be less than honest at this point if I didn"t tell you that experience with keeping a media diary matters here. As time pa.s.ses and your diary lengthens, you will get better at selecting the stories that are really helpful for a.s.sessing the state of an investment crowd and at ignoring the ones that are of only marginal use. Knowing just which stories are important partly comes from firsthand knowledge of what goes on in markets on a day-by-day basis. It also arises from my knowledge of where market prices stand relative to recent and historical ranges and extremes. This skill has taken many years to develop but proves invaluable time and again. You can develop it, too, with practice. (That is why you should start your media diary now.) When I first started keeping a media diary, I tended to clip far too many stories. I thought that the diary would permit some sort of statistical a.n.a.lysis of media content. I soon learned that this was not only impractical but wrongheaded. The media diary"s real value lies in the experience of reading the headlines and the articles in your diary against the backdrop of market behavior at the time. By doing this you get a sense of the mood of the crowd that you can get in no other way. More important, you acquire a feel for the intensity of an investment crowd"s emotional reaction to market and economic events. This intensity of feeling and belief is something only my media diary can convey to me. It can be judged in no other way. This is one reason that statistical, survey-based approaches to contrarian trading tend to have little value. They don"t give you the ability to a.s.sess the intensity of an investment crowd"s beliefs, fears, and hopes.

Once I have clipped what I need from the daily newspapers, I go down to my office and check a number of news web sites together with several market-oriented and a few general-interest blogs. I don"t often put material from these sources in my media diary. Only once or twice a week on average do I find a story or opinion piece that I feel gives useful information about one of the investment crowds I am tracking. Recently I have started to save screen shots of headlines of web sites (like Market.w.a.tch) that are devoted solely to financial markets. I am sure that as time pa.s.ses and electronic sources become increasingly important parts of the media industry I"ll devote more time to capturing and recording their messages to investment crowds, too.

Once I"ve checked my Internet sources, I glance at the magazines that may have arrived in the mail. I don"t subscribe to every magazine that might have useful content. Instead I check each magazine"s web site for the latest issue. It is usually easy to see just by looking at its cover whether there is any content related to investment crowds in the magazine.

When I find a cover story that is market related, I tear off the cover and staple it to the inside pages of the a.s.sociated story. If I don"t already subscribe to the magazine, I try to buy a copy from my local bookstore. If this isn"t possible, I return to the magazine"s web site and print out a copy of the story along with an image of any a.s.sociated cover. These magazine stories I file in a folder labeled "cover stories." I have another folder containing stories of contrarian interest that aren"t cover stories and are too long to put in my spiral notebook media diary.

EXCERPTS FROM MY MEDIA DIARY: NOVEMBER 2005.

I"d like to give you a more detailed ill.u.s.tration of what my diary actually looks like so that you can get a better sense of the kinds of stories it contains. My object now is not to explain in any detail how the diary can help you to make investment decisions. Instead my immediate goal is to give examples of stories I see as important, examples of materials I like to preserve in my diary, and examples of the sort of market consequences this information can lead you to antic.i.p.ate.

I have just pulled down from my shelf of media diaries the one containing content that appeared between October 25, 2005, and September 18, 2007, a period of about 23 months. Generally I find that anywhere from 18 to 30 months of material will fill up a single five-subject spiral notebook. Exactly how many months of material it will take depends on the nature of the markets at the time. Quiet markets generate less media commentary than do volatile ones or ones setting records of one sort or another.

The first entry in this diary was a story that appeared on November 4 in the business section of the New York Times New York Times (henceforth abbreviated (henceforth abbreviated NYT NYT). It was headed "Bears Have Their Day" and discussed the fact that 2005 had been a good year for hedge funds specializing in short selling. I clipped this article because I knew that whenever the short sellers are prominent in the newspaper it is time to buy stocks. This was no exception. The S&P 500 rose from about 1,220 when this story appeared to about 1,450 on the last day recorded in this diary.

The next clipping was a Wall Street Journal Wall Street Journal story on November 8 headed "Foreign Stocks Get New Push." The story tells of Wall Street firms raising their allocation levels to foreign stocks to record levels. Foreign stocks make money for investors primarily when the dollar falls, so I interpreted this story as a bet against the then rising trend of the dollar. It was definitely story on November 8 headed "Foreign Stocks Get New Push." The story tells of Wall Street firms raising their allocation levels to foreign stocks to record levels. Foreign stocks make money for investors primarily when the dollar falls, so I interpreted this story as a bet against the then rising trend of the dollar. It was definitely not not a story that reinforced the bullish trend in the dollar at the time. In fact, about a month later the dollar started a 30-month, 24 percent drop and thus made these Wall Street firms look like geniuses. I should say that I did not see this big drop in the dollar coming, largely because of stories like this one that did not indicate the presence yet of a significant bullish dollar crowd. a story that reinforced the bullish trend in the dollar at the time. In fact, about a month later the dollar started a 30-month, 24 percent drop and thus made these Wall Street firms look like geniuses. I should say that I did not see this big drop in the dollar coming, largely because of stories like this one that did not indicate the presence yet of a significant bullish dollar crowd.

The November 14 issue of Newsweek Newsweek provided my next diary entry. It was Robert J. Samuelson"s column ent.i.tled "Worry While You Spend," which had a great interlinear subhead: "What explains the gap between Americans" glum mood and their free-spending ways?" I clipped this story because it reinforced my view that no bullish stock market crowd had developed despite a three-year rally from the 2002 low, which had already carried the S&P 500 from 768 to 1,220. I found this remarkable, but I should emphasize that the absence of a crowd tells you nothing in and of itself about prospective market direction. (See the previous paragraph about the dollar for emphasis of this fact.) provided my next diary entry. It was Robert J. Samuelson"s column ent.i.tled "Worry While You Spend," which had a great interlinear subhead: "What explains the gap between Americans" glum mood and their free-spending ways?" I clipped this story because it reinforced my view that no bullish stock market crowd had developed despite a three-year rally from the 2002 low, which had already carried the S&P 500 from 768 to 1,220. I found this remarkable, but I should emphasize that the absence of a crowd tells you nothing in and of itself about prospective market direction. (See the previous paragraph about the dollar for emphasis of this fact.) My next entry was a story dated November 4 that appeared on the Market.w.a.tch web site. Note that it was pasted into my diary out of proper chronological sequence. This sort of thing happens, especially with Web or magazine content, and I don"t worry too much about it. But I am careful always to note the source of every clipping and the date of its appearance.

This Market.w.a.tch story was a column by Mark Hulbert, who edits the Hulbert Financial Digest Hulbert Financial Digest, a newsletter that tracks the recommendations and market performance of financial newsletters. I have found Hulbert"s columns very informative at times because he himself is a devotee of the contrarian art. Moreover, he has at his disposal hard data about opinions, which would be very difficult for any individual to duplicate. In this particular column Hulbert tells the reader that the bond market timing newsletters he tracks at the Hulbert Financial Digest Hulbert Financial Digest have as a group never been more bearish on bond prices. He offers statistical evidence to back up this observation. I should note that according to my records the bond market made a low point on November 4 and then rallied for two consecutive months. However, after the rally bond prices eventually dropped below their November 4 low. Nonetheless, Hulbert"s contrarian warning was a very valuable piece of information for a contrarian trader, and the subsequent market rally was normal for the kind of evidence that Hulbert offered in his column. have as a group never been more bearish on bond prices. He offers statistical evidence to back up this observation. I should note that according to my records the bond market made a low point on November 4 and then rallied for two consecutive months. However, after the rally bond prices eventually dropped below their November 4 low. Nonetheless, Hulbert"s contrarian warning was a very valuable piece of information for a contrarian trader, and the subsequent market rally was normal for the kind of evidence that Hulbert offered in his column.

Along the same lines was a Wall Street Journal Wall Street Journal story dated November 17, which was pasted into my diary just after the Hulbert column. It was headed "A Message in the Bond Market." It warned that the yield curve was about to invert and said this was bearish for bond market investors. The story reinforced my view at the time that bond prices would rally at least for a couple of months. story dated November 17, which was pasted into my diary just after the Hulbert column. It was headed "A Message in the Bond Market." It warned that the yield curve was about to invert and said this was bearish for bond market investors. The story reinforced my view at the time that bond prices would rally at least for a couple of months.

The next story pasted into my diary was a brief column that appeared in the business section of the New York Times New York Times and was headed "Rapid Rise: Google Pa.s.ses $400 a Share." I saved this not because I thought it had immediate market significance but because I wanted to keep the story of the Google crowd current in my diary. I had been following it for 15 months, ever since Google"s initial public offering (IPO) at $85 per share in August 2004. The reason for my early interest was a very unusual circ.u.mstance surrounding this IPO. At the time, the investment crowd focused on Google was a bearish one, not the bullish crowd one normally expects to see at the time of an IPO. This was so unusual that I noted it and brought it to the attention of my clients. I began commenting on Google in the web log I started in 2005 (you can find it by googling my name). My basic theme was that until the bearish crowd in Google morphed into a bullish one, Google"s stock price would probably rise far more than anyone expected. In April 2005 with the stock trading at $224 I cited a $500 target, but this proved to be way too conservative. By November 2007 Google had reached $747. and was headed "Rapid Rise: Google Pa.s.ses $400 a Share." I saved this not because I thought it had immediate market significance but because I wanted to keep the story of the Google crowd current in my diary. I had been following it for 15 months, ever since Google"s initial public offering (IPO) at $85 per share in August 2004. The reason for my early interest was a very unusual circ.u.mstance surrounding this IPO. At the time, the investment crowd focused on Google was a bearish one, not the bullish crowd one normally expects to see at the time of an IPO. This was so unusual that I noted it and brought it to the attention of my clients. I began commenting on Google in the web log I started in 2005 (you can find it by googling my name). My basic theme was that until the bearish crowd in Google morphed into a bullish one, Google"s stock price would probably rise far more than anyone expected. In April 2005 with the stock trading at $224 I cited a $500 target, but this proved to be way too conservative. By November 2007 Google had reached $747.

The November 28 issues of BusinessWeek BusinessWeek and and Fortune Fortune gave me my next two diary entries. The gave me my next two diary entries. The BusinessWeek BusinessWeek story was headed "This Spree Could Spur a Stock Surge." It described how the boom in private equity purchases of public companies was adding fuel to the stock market advance from its 2002 lows. I believed this to be an accurate a.s.sessment of one of the reasons for the bull market in stocks, and I clipped the article because I wanted to keep tracking this story until its end-which probably would be a.s.sociated with an important stock market top (it was, in 2007). The story was headed "This Spree Could Spur a Stock Surge." It described how the boom in private equity purchases of public companies was adding fuel to the stock market advance from its 2002 lows. I believed this to be an accurate a.s.sessment of one of the reasons for the bull market in stocks, and I clipped the article because I wanted to keep tracking this story until its end-which probably would be a.s.sociated with an important stock market top (it was, in 2007). The Fortune Fortune story was of a different sort. It was ent.i.tled "Investors Are In for a Shock" and subt.i.tled "Financial a.s.sets are richly priced." The article is accompanied by a cartoon of an investor who has climbed a staircase but, like Wile E. Coyote, has continued past the end of the staircase and now hovers in midair (prior to a crash). I love to paste stories that are accompanied by interesting photographs, cartoons, or charts into my diary. They always have more emotional intensity than media content without any particular visual interest. This particular story a.s.serted that the returns on financial a.s.sets are likely to be far worse than people expect. I should point out that the bull market in stocks had two more years to run at the time this story appeared. I clipped the column as evidence that a bullish stock market crowd had not yet formed. story was of a different sort. It was ent.i.tled "Investors Are In for a Shock" and subt.i.tled "Financial a.s.sets are richly priced." The article is accompanied by a cartoon of an investor who has climbed a staircase but, like Wile E. Coyote, has continued past the end of the staircase and now hovers in midair (prior to a crash). I love to paste stories that are accompanied by interesting photographs, cartoons, or charts into my diary. They always have more emotional intensity than media content without any particular visual interest. This particular story a.s.serted that the returns on financial a.s.sets are likely to be far worse than people expect. I should point out that the bull market in stocks had two more years to run at the time this story appeared. I clipped the column as evidence that a bullish stock market crowd had not yet formed.

EXCERPTS FROM MY MEDIA DIARY: JUNE 2006.

I put only eight stories in my diary during the month of November 2005. It was a slow month but an otherwise typical one. The markets were generally stable or rising at the time. You will find that most months won"t provide diary material dramatic enough to call for any investment actions. Just the opposite is true for months a.s.sociated with stock market drops. The pages of my media diary fill rapidly at such times. One of these months was June 2006.

On May 5, 2006, the S&P 500 index closed at 1,325. It fell the rest of the month and reached a low close of 1,223 on June 13. This was a relatively quick 8 percent drop in prices, normal for a bull market. From the June 13 low the index would rally to a high close of 1,575 in October 2007, an advance of 29 percent. Here is what I recorded in my media diary during June 2006.

The first story of the month was another column by Mark Hulbert. It had nothing to do with the stock market. Instead Hulbert"s focus was on gold, which had reached a high of $725 early in May along with the stock market and had since dropped about $100 per ounce. I should note that the actual low of this drop occurred on June 14 with gold selling at about $550. Hulbert noted in this column that gold timing newsletters had by late May moved from a very bullish stance to a position of being on average completely out of the gold market. He interpreted this bullishly. As I have said, I like to keep a record of Hulbert"s views because he tries to take a contrarian view of the markets and often offers useful facts to back them up.

The next diary entry was a column by Daniel Gross from the New York Times New York Times business section of June 4. In it he noted the strong performance of the U.S. economy during the first quarter of 2006 and contrasted this with consumers" rather pessimistic expectations of the future. I thought this was significant, again because it suggested there was no important bullish crowd then active in the stock market. business section of June 4. In it he noted the strong performance of the U.S. economy during the first quarter of 2006 and contrasted this with consumers" rather pessimistic expectations of the future. I thought this was significant, again because it suggested there was no important bullish crowd then active in the stock market.

On June 6 the Wall Street Journal Wall Street Journal headlined its personal section with a story headed "Cash Becomes a Hot Investment." The story said that stock market volatility and rising interest rates were prompting investors to shift into money market funds and certificates of deposit (CDs). I interpreted this as a bullish omen for both the stock and bond markets. I have already explained what followed for the S&P 500 index. The bond market rallied for six months from its June 2006 lows. headlined its personal section with a story headed "Cash Becomes a Hot Investment." The story said that stock market volatility and rising interest rates were prompting investors to shift into money market funds and certificates of deposit (CDs). I interpreted this as a bullish omen for both the stock and bond markets. I have already explained what followed for the S&P 500 index. The bond market rallied for six months from its June 2006 lows.

That same day I clipped a Wall Street Journal Wall Street Journal story by E. S. Browning that was headed "Dow Falls 1.77% as Fed Chief Adds to Investor Jitters." This merited inclusion in my diary because of the use of the word story by E. S. Browning that was headed "Dow Falls 1.77% as Fed Chief Adds to Investor Jitters." This merited inclusion in my diary because of the use of the word jitters jitters, an indicator that fears were building among stock market investors.

Next among the June 2006 diary entries were two out-of-sequence entries of content from the Internet. Both appeared on June 5. The first was a Market.w.a.tch column by Peter Brimelow, which reported the gold bug Harry Schultz"s prediction that gold was headed for $3,000 per ounce. The second item was a column by Michael Barone, political commentator. I underlined the most important sentence of his piece: "Yet Americans are in a sour mood, a mood that may be explained by the lack of a sense of history." This clipping was only a small contribution to the story of a general disconnect between actual economic conditions and Americans" views of the future. I didn"t see this as a situation encouraging the development of a bullish stock market crowd.

"Foreign Markets Extend Decline as Rate Fears Curb Risk Appet.i.te" was the headline of a front page, below-the-fold story in the Wall Street Journal Wall Street Journal on June 9 that I clipped for my diary. The phrase on June 9 that I clipped for my diary. The phrase rate fears rate fears I felt had bullish implications for the stock market and for interest rates. My attention is attracted to stories that contain phrases indicating strong emotions of one sort or another. I felt had bullish implications for the stock market and for interest rates. My attention is attracted to stories that contain phrases indicating strong emotions of one sort or another.

From the June 12 edition of Barron"s Barron"s I clipped part of the "Up and Down Wall Street" column, which that week was written by Michael Santoli. In it he made two observations that put him in both bullish short-term (right) and bearish long-term (wrong) camps. I underlined in red these sentences: I clipped part of the "Up and Down Wall Street" column, which that week was written by Michael Santoli. In it he made two observations that put him in both bullish short-term (right) and bearish long-term (wrong) camps. I underlined in red these sentences: [A]nxiety levels, measured both statistically and anecdotally, seem to have risen more than the 5% to 6% decline from recent stock-index highs would warrant.

and then: [T]here"s an emerging sense of foreboding auguring a less-generous [market] environment.

On June 13 I clipped an item from Bill Cara"s blog. It showed a picture of a black bear and was accompanied by this comment: As traders are now glued to their screens in hopes of seeing some evidence that today and tomorrow"s U.S. inflation data will permit the funds rate to fall, this is the picture they are getting.

The Wall Street Journal Wall Street Journal had a front page story on June 14, the day after the low was made in the S&P 500, which was headed: "Tumbling Markets May Be Reflection of Strong Growth-Investors Struggle to Adapt to Demise of Easy Money; Dow Gives Up 2006 Gains." That same day the had a front page story on June 14, the day after the low was made in the S&P 500, which was headed: "Tumbling Markets May Be Reflection of Strong Growth-Investors Struggle to Adapt to Demise of Easy Money; Dow Gives Up 2006 Gains." That same day the Wall Street Journal Wall Street Journal"s markets section was headlined: "Interest-Rate Fears Drive World-Wide Slide." The next day the New York Times New York Times had a front page story, placed right next to the headline story, which was headed: "A Modest Rise Still Amplifies Inflation Fears-Lessons of 70"s Prompt Strong Warnings." had a front page story, placed right next to the headline story, which was headed: "A Modest Rise Still Amplifies Inflation Fears-Lessons of 70"s Prompt Strong Warnings."

On June 16, on its front page, the New York Times New York Times published a line chart of the Dow Jones Industrial Average recording the drop from its May 10 top. The caption of the graph said: "Relief, at Least for Now." But in the text of the caption one finds: "But the increased volatility in the markets suggested that their troubles may not be over." The graph was interesting not just because of this text but because it showed a picture of a market in the process of dropping. Images like this one are very good reflections of emotional states and serve also to amplify these emotions, in this case fear. published a line chart of the Dow Jones Industrial Average recording the drop from its May 10 top. The caption of the graph said: "Relief, at Least for Now." But in the text of the caption one finds: "But the increased volatility in the markets suggested that their troubles may not be over." The graph was interesting not just because of this text but because it showed a picture of a market in the process of dropping. Images like this one are very good reflections of emotional states and serve also to amplify these emotions, in this case fear.

The Chicago Tribune Chicago Tribune of June 16 was headlined, in reference to Ben Bernanke, chairman of the Federal Reserve: "When Big Ben Speaks of June 16 was headlined, in reference to Ben Bernanke, chairman of the Federal Reserve: "When Big Ben Speaks . . . . . . the Market Reacts." The headline was accompanied by an intraday chart of the Dow for the previous day, which showed the start of a rally when Bernanke started to deliver a speech in Chicago. the Market Reacts." The headline was accompanied by an intraday chart of the Dow for the previous day, which showed the start of a rally when Bernanke started to deliver a speech in Chicago.

At this point you have probably noticed that the frequency of stories that I believed pushed emotional b.u.t.tons increased around the time of the market low on June 13. This is typical of the media content a.s.sociated with low points in the stock market. The stronger the display of emotion via story frequency and intensity, the more important and long-lasting will be the low. Highs, by contrast, tend to occur against a more diffuse background, sometimes accompanied by an absence of strong emotion of any kind. We discuss this in more detail in Chapter 9.

The June 19 issue of Barron"s Barron"s was interesting for several reasons. First, the inveterate stock market bear, Alan Abelson, noted in his column that the latest Investors Intelligence survey of market letters showed more bearish sentiment than at any time since the bear market low of October 2002. He observed that this meant that some sort of bounce (rally) was inevitable. But then he went on to dispute the longer-term implications of these numbers: "[W]e suspect that the glimpse of reality that unhinged the markets will become the increasingly prevailing view in the months ahead." In other words, Abelson dismissed the longer-term significance of the large bearish contingent in the survey, arguing instead that, aside from a short-term bounce, the bears would be right this time. In my experience there is nothing as bullish as a bearish view that explicitly dismisses the significance of widespread bearish sentiment. was interesting for several reasons. First, the inveterate stock market bear, Alan Abelson, noted in his column that the latest Investors Intelligence survey of market letters showed more bearish sentiment than at any time since the bear market low of October 2002. He observed that this meant that some sort of bounce (rally) was inevitable. But then he went on to dispute the longer-term implications of these numbers: "[W]e suspect that the glimpse of reality that unhinged the markets will become the increasingly prevailing view in the months ahead." In other words, Abelson dismissed the longer-term significance of the large bearish contingent in the survey, arguing instead that, aside from a short-term bounce, the bears would be right this time. In my experience there is nothing as bullish as a bearish view that explicitly dismisses the significance of widespread bearish sentiment.

In that same issue, Barron"s Barron"s had two stories that were also relevant for the stock market. The first was the midyear roundtable of market seers offering their predictions for the second half of 2006. The story was headed: "High Anxiety." Wow! Seldom does one come across an emotion-laden headline like this one. had two stories that were also relevant for the stock market. The first was the midyear roundtable of market seers offering their predictions for the second half of 2006. The story was headed: "High Anxiety." Wow! Seldom does one come across an emotion-laden headline like this one.

The second story was about a fellow named Robert A. Haugen. Haugen"s thesis was that increasing stock market volatility was inevitable and would set the stage for depression or worse. He recommended shutting the stock market for two days a week to calm things down. This Barron"s Barron"s story ill.u.s.trates a general principle. Journalists may not reveal their biases to you directly, but they often will do so indirectly though their choice of story material. Moreover, this very choice of subject matter reveals their perception of readers" interests and concerns. In this instance the choice of Haugen as the subject for this story was essentially an attempt to appeal to the current fears of story ill.u.s.trates a general principle. Journalists may not reveal their biases to you directly, but they often will do so indirectly though their choice of story material. Moreover, this very choice of subject matter reveals their perception of readers" interests and concerns. In this instance the choice of Haugen as the subject for this story was essentially an attempt to appeal to the current fears of Barron"s Barron"s readers and to offer an implicit bearish prediction of the future. readers and to offer an implicit bearish prediction of the future.

The June 18 Sunday edition of the New York Times New York Times had a column by Mark Hulbert in which he also catered to the then-current bearish sentiment. In its first paragraph he says: "Bad news, stock investors: the market is likely to underperform garden-variety money market funds through the end of next year." had a column by Mark Hulbert in which he also catered to the then-current bearish sentiment. In its first paragraph he says: "Bad news, stock investors: the market is likely to underperform garden-variety money market funds through the end of next year."

There are a handful of other stories I put into my diary later that month, but they all reinforce the theme, which I think you can see clearly by now. As the market reached its June 13 low in 2006, more and more stories appeared encouraging readers to think prices would go still lower.

This example also ill.u.s.trates an important media diary principle: Look for media messages that tend to reinforce the view that recent market movements will continue. These are the messages that fuel information cascades and that will enable you to a.s.sess the strength of investment crowds.

INTERPRETING MAGAZINE COVERS.

An important part of my media diary is my collection of magazine covers. I keep these in chronological order in separate file folders labeled by year of appearance. I described the magazines I monitor regularly in the previous chapter, but any weekly or monthly magazine can be the source of a cover that speaks to an investment crowd.

I first learned the value of using magazine covers in contrarian trading from Paul Macrae Montgomery. In the early 1970s Paul observed that when Time Time magazine had a cover story about a prominent business personality, about the stock market, or about some other finance-related matter, one could often infer that an important move in the markets was imminent, a move that was likely to be in the direction opposite to what the cover suggested. Optimistic covers led to unexpected drops in prices, while pessimistic covers had the opposite effect. magazine had a cover story about a prominent business personality, about the stock market, or about some other finance-related matter, one could often infer that an important move in the markets was imminent, a move that was likely to be in the direction opposite to what the cover suggested. Optimistic covers led to unexpected drops in prices, while pessimistic covers had the opposite effect.

The theory behind this phenomenon is a simple one. If a business- or stock market-related story makes it onto a Time Time cover, this means that it has already caught the popular imagination and is the theme of a large investment crowd. This is true precisely because cover, this means that it has already caught the popular imagination and is the theme of a large investment crowd. This is true precisely because Time Time covers rarely concern business topics. When they do they must reflect opinion that has been accepted by the general population of investors. In such circ.u.mstances the investment crowd has little capacity for growth, and the time for its disintegration is probably at hand. covers rarely concern business topics. When they do they must reflect opinion that has been accepted by the general population of investors. In such circ.u.mstances the investment crowd has little capacity for growth, and the time for its disintegration is probably at hand.

In the next chapter I"ll have more to say about general guidelines for using magazine cover stories to identify investment crowds. For now I"d just like to explain a few criteria you can use to determine whether a cover story is important enough to put into your diary.

First, you want the cover story to focus on a specific financial market or a specific stock. This is important because investment crowds organize themselves around specific markets. The cover itself might highlight a person who is closely a.s.sociated with the market, for example the company"s CEO or the chairman of the Federal Reserve. You want to look for covers offering implicit predictions for the direction of the market or some emotional response to the market"s recent behavior, the more definitive the better.

Covers that talk about the condition of the whole economy generally do not give useful information about investment crowds. I save these sorts of covers as indicators of general mood but don"t use them to a.s.sess the status of investment crowds. In contrast, covers that speak of the levels of interest rates or inflation can be useful in identifying bond market investment crowds.

The most important feature of an important cover story is its emotional content. The more the cover appeals to fear or to greed, the stronger its implication for the imminent demise of an investment crowd. To ill.u.s.trate how I select covers for my media diary, let"s look at the cover stories I saved from the year 2006.

The first cover story was from Time Time magazine"s January 30 issue. The cover showed Bill Ford of Ford Motor Company and asked: "Would You Buy a New Car from This Man?" The cover caption suggested Ford had big ideas for saving his company and the auto industry. The significance of this cover story was hard to judge. It appeared after a 50 percent drop in the price of Ford stock from $16 to $8 over the preceding two years. One would expect such a cover to express bearish sentiments. But instead it seemed to offer hope to investors that the worst might be past. One should note that the price of Ford stock was essentially unchanged during the subsequent two years. magazine"s January 30 issue. The cover showed Bill Ford of Ford Motor Company and asked: "Would You Buy a New Car from This Man?" The cover caption suggested Ford had big ideas for saving his company and the auto industry. The significance of this cover story was hard to judge. It appeared after a 50 percent drop in the price of Ford stock from $16 to $8 over the preceding two years. One would expect such a cover to express bearish sentiments. But instead it seemed to offer hope to investors that the worst might be past. One should note that the price of Ford stock was essentially unchanged during the subsequent two years.

The next cover story of interest also concerned the auto industry and appeared in Fortune Fortune"s February 20 issue. Unlike the warm red, yellow, and green colors of the Time Time cover, this cover appeared with a depressing black background with a blue GM logo. The cover was headed: "The Tragedy of General Motors." The cover caption read: "It is the instinctive wish of most businesspeople that General Motors not go bankrupt. cover, this cover appeared with a depressing black background with a blue GM logo. The cover was headed: "The Tragedy of General Motors." The cover caption read: "It is the instinctive wish of most businesspeople that General Motors not go bankrupt.... And yet the evidence points, with increasing cert.i.tude, to bankruptcy." GM stock had dropped from $45 to $17 over the preceding two years, a much bigger percentage drop than Ford"s. Moreover, this GM cover was starkly bearish in tone. As such, it was a strong indication that the bear crowd had grown large and complacent about GM. The price of GM went from $17 to $42 over the subsequent 20 months. And yet the evidence points, with increasing cert.i.tude, to bankruptcy." GM stock had dropped from $45 to $17 over the preceding two years, a much bigger percentage drop than Ford"s. Moreover, this GM cover was starkly bearish in tone. As such, it was a strong indication that the bear crowd had grown large and complacent about GM. The price of GM went from $17 to $42 over the subsequent 20 months.

The February 12 cover of Barron"s Barron"s featured Google"s logo Photo-shopped to read "Gurgle." The logo was shown sinking beneath the water in a washbasin or tub, the implication being that Google was going down the drain. At the time, Google"s stock had dropped about 100 points from its early 2006 high of $475 and would drop a bit further to a March low of $331. But over the subsequent 20 months the price of Google"s stock would advance from $331 to $747. featured Google"s logo Photo-shopped to read "Gurgle." The logo was shown sinking beneath the water in a washbasin or tub, the implication being that Google was going down the drain. At the time, Google"s stock had dropped about 100 points from its early 2006 high of $475 and would drop a bit further to a March low of $331. But over the subsequent 20 months the price of Google"s stock would advance from $331 to $747.

It is interesting to note that a week later Time Time magazine also had a Google cover story. This story was headed: "Can We Trust Google with Our Secrets?" This magazine cover told me little about the Google bullish investment crowd. It was not very specific and didn"t imply any particular direction for Google"s stock, even though it did have some emotional content, as revealed by the use of the word magazine also had a Google cover story. This story was headed: "Can We Trust Google with Our Secrets?" This magazine cover told me little about the Google bullish investment crowd. It was not very specific and didn"t imply any particular direction for Google"s stock, even though it did have some emotional content, as revealed by the use of the word trust trust.

The next cover of interest to me during 2006 was the cover of Barron"s Barron"s May 1 issue. It depicted a bull reclining comfortably against two pillows with a big smile on his face. The story was headed: "Dow 12,000." The Dow Jones Industrial Average reached a high at 11,700 just a week later and then dropped sharply to 10,700 during the market break, which ended in June 2006. This story was an unusual example of a bullish cover that precisely timed a scary short-term drop in the stock market. May 1 issue. It depicted a bull reclining comfortably against two pillows with a big smile on his face. The story was headed: "Dow 12,000." The Dow Jones Industrial Average reached a high at 11,700 just a week later and then dropped sharply to 10,700 during the market break, which ended in June 2006. This story was an unusual example of a bullish cover that precisely timed a scary short-term drop in the stock market.

The May 27-June 2 issue of the Economist Economist showed a brown bear on its hind legs peeking out from behind a tree. It was headed: "Which Way Is Wall Street?" This was a specific prediction of declining stock prices. A bull or a bear that appears on a magazine cover after the market has risen or dropped a substantial amount is usually a sign that the price movement is about to reverse. The low in the S&P occurred at 1,223 on June 13, and the average reached the 1,575 level 16 months later. showed a brown bear on its hind legs peeking out from behind a tree. It was headed: "Which Way Is Wall Street?" This was a specific prediction of declining stock prices. A bull or a bear that appears on a magazine cover after the market has risen or dropped a substantial amount is usually a sign that the price movement is about to reverse. The low in the S&P occurred at 1,223 on June 13, and the average reached the 1,575 level 16 months later.

I remember being particularly impressed by the cover story of the New York Times Magazine New York Times Magazine"s June 11 issue. It showed a black background against which a hairy, giant "debt monster" was pursuing little people who were running from it in blind terror. The cover caption was cla.s.sic: "America"s Scariest Addiction Is Getting Even Scarier." The color scheme and the double use of the adjectives scariest scariest and and scarier scarier showed strong emotional content. Appearing as it did after a monthlong drop in the stock market, it strengthened and amplified the emotions of the bearish crowd that had developed by then. showed strong emotional content. Appearing as it did after a monthlong drop in the stock market, it strengthened and amplified the emotions of the bearish crowd that had developed by then.

Next we come to two cover stories that ill.u.s.trate that one cannot blindly take a market position opposite to that implied by a magazine cover. These stories appeared in the July 24 and November 6 issues of Barron"s Barron"s. The July 24 cover said "Time to Buy," and this advice was right on the mark. The November 6 cover was headed: "Next Stop 13,000?" The appearance of the question mark weakened the significance of this story, but nonetheless the Dow made it up to the 13,700 level the following year before any substantial reaction set in.

The important thing to keep in mind about cover stories is that they are significant only if they are specific in their implications and if they reinforce the belief that current market trends will continue.

CHAPTER 9.

Important Investment Themes Investment themes * * long-lived versus short-lived themes long-lived versus short-lived themes * * first the market moves first the market moves * * then comes the rationale then comes the rationale * * categories of themes categories of themes * * new era themes new era themes * * things are always different this time things are always different this time * * the abandonment of traditional valuation standards the abandonment of traditional valuation standards * * war and political crises war and political crises * * bearish crowds are common bearish crowds are common * * war crowds form and disintegrate quickly war crowds form and disintegrate quickly * * in the United States buy the outbreak of shooting in the United States buy the outbreak of shooting * * sell peace sell peace * * financial crises financial crises * * generally very brief generally very brief * * most intense bearish crowd forms just before resolution most intense bearish crowd forms just before resolution * * the subprime crisis the subprime crisis * * individual companies and industries individual companies and industries * * Google Google * * commodity booms commodity booms * * oil at $147 and gold at $1,000 oil at $147 and gold at $1,000 * * interest rates and the bond market interest rates and the bond market * * predicting a 25-year drop in interest rates in 1982 predicting a 25-year drop in interest rates in 1982 * * using your media diary to track investment themes using your media diary to track investment themes TELLING THE MARKET"S STORY Your media diary contains need-to-know information about developing investment themes. Remember that investment crowds develop around investment themes. An investment theme is a rationale for market behavior. It tells the market"s story by explaining why prices have changed so dramatically and by offering, at least implicitly, a prediction for their direction in the immediate future. The explanatory nature of an investment theme is important here. It is this apparently logical explanation of the past that sustains the a.s.sociated information cascade. This is the identifying feature of any investment theme around which an investment crowd will develop.

In Chapter 5 I discussed some of the investment themes that were a.s.sociated with the stock market bubble of 1994-2000 and with the subsequent bear market of 2001-2002. These were very important investment themes-the a.s.sociated crowds were big and long-lived. The bubble crowds" life cycles each extended over several years, while the bear market crowd"s life span was about 24 months. But investment themes and their crowds can be short-lived as well. This is especially true of the bearishly themed stock market crowds. On average, bearish crowds disintegrate sooner than bullish crowds. Moreover, one often finds a very short-lived bearish crowd developing in response to some external event, which is blamed for a relatively brief drop in the averages, say one lasting a few weeks and amounting to 5 percent or a little more. In Chapter 8 we saw an example of such a crowd forming during June 2006. At that time the external event was a rise in interest rates, which was blamed for generating fears that the Federal Reserve would pursue a tighter monetary policy.

When you use your diary material to identify an investment theme, keep in mind the basic sequence of events accompanying the development of any investment crowd. First comes a dramatic rise or fall in the market averages or in the price of an individual stock or industry group. This generates media content, which notes this price change and offers an explanation for it. These media explanations will increase in number, frequency, and emotional intensity as long as the a.s.sociated price trend continues. This is the evidence you look for to tell you that an information cascade is under way. Your job as a contrarian trader is to a.s.sess the current strength of the crowd and to use available historical precedents to make an educated guess about where the crowd is in its life cycle.

In principle, an investment theme may tell any plausible story or even offer a completely novel explanation for a change in market prices. Even so, I have found that most investment themes fall into a small number of categories. It"s useful to know what these categories are and to be familiar with a number of historical examples of each. Background knowledge like this makes real-time identification of investment themes an easier task.

NEW ERAS.

Every generation or so, the stock market in the United States experiences a multiyear advance in prices that multiplies the market averages several times and is not interrupted by any significant, sustained downward move. These advances enrich the typical investor and always encourage the development of one or more bullish investment crowds. The cla.s.sic examples are the 1921-1929 bull market, during which the Dow Jones Industrial Average rose from 60 to 380, and the 1994-2000 bull market, during which the same average advanced from 3,800 to 11,750. An equally dramatic example is the 1949-1966 bull market, during which the Dow rose from 169 to 1,000.

As these sustained advances in stock prices proceed, one invariably finds a particular kind of investment theme emerging, a theme I like to call the "new era" theme. People notice that stock prices have been advancing steadily and have already risen higher than normal in a typical economic expansion. Investors want to know why why this is happening. The media are happy to meet this demand for answers. The usual explanation is that there are new industries or technological or financial innovations that are driving the economy to previously unseen heights of prosperity. In the 1920s the boom was in radio (the new technology of that decade) and the automobile industry. Installment credit was the financial innovation of the time, and it multiplied the purchasing power of the era"s consumers. The new era of the 1960s was a.s.sociated with the computer, electronic, and airline industries. The princ.i.p.al financial innovation of the time was a macroeconomic one-Keynesian economics had triumphed in the economics profession, and many believed that its prescriptions had made recessions a thing of the past. There were two other innovations of note. The first was the concept of the industrial conglomerate-a merger of firms in different industries, which supposedly allowed shrewd management to extend its reach and effects, and which diversified the risks of industry-specific business performance. The second innovation was the concept of the high-capitalization, perpetual growth stock, neatly encapsulated in the Nifty Fifty growth stocks, which predominated inst.i.tutional portfolios in the early 1970s. During the dot-com years of 1994-2000 the new technology was the Internet and the personal computer. When the globalization of markets (which

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