TableofContents

TitlePageCopyrightPagePrefaceCHAPTER1-CanYouBeattheMarket?

THESPECULATOR’SEDGELENDINGAHELPING

HANDTOINVESTORSUNCOVERING

MARKETMISTAKESLOOKINGATTHE

EVIDENCEMARKETTIMINGCATCH-22

CHAPTER2-MarketMistakes

EFFICIENTMARKETSROLLERCOASTERS

ANDSTOCKMARKETSDOSTOCKPRICES

FLUCTUATETOOMUCH?ALOOKAT

BEHAVIORALFINANCEBEHAVIORAL

FINANCEANDEXPLOITABLEMARKETMISTAKES

NOFREELUNCHREDUX

CHAPTER3-TheEdge

ATHEORYOFMARKETMISTAKESTOGETALONG,GO

ALONGGOALONGAND

CREATEAMISTAKETHESOCIAL

CALCULUSOFCROWDSTHEVISIONOFA

CONTRARIANTRADERCHAPTER4-TheWisdomandFolliesofCrowds

CANACROWDBEWISERTHANITSMEMBERS?THENEEDFOR

COLLECTIVEWISDOMINDEPENDENT

DECISIONSINTHEFINANCIALMARKETSFORECASTING

MARKETPSYCHOLOGYINFORMATION

CASCADESINTOTHEWHIRLPOOLOFSPECULATION

CHAPTER5-TheLife

CycleandPsychologyofanInvestmentCrowd

PROLOGUETHECYCLEOF

BIRTHANDDEATHTHESTOCKMARKET

BUBBLEOF1994-2000IT’SDIFFERENTTHIS

TIME:THENEWINFORMATIONECONOMYSHATTERED

DREAMS:THEBEARCROWDOF2001-2002POPULARINSTINCTS

ANDTHESEARCHFORCERTAINTYTHEPIEDPIPERSOF

INVESTMENTCROWDSTHEMENTALUNITY

OFINVESTMENTCROWDSSUGGESTIBILITY,

VOLATILITY,ANDDISINTEGRATION

CHAPTER6-TheHistoricalContextforMarketMistakes

MATUREINVESTMENTTHEMESANDMARKETCROWDSMISTAKESVERSUS

FAIRVALUEMARKETDATA

SOURCES

THEDEADLYMISTAKEWHENISTHESTOCK

MARKET(EXTREMELY)OVERVALUED?WHENISTHESTOCK

MARKETUNDERVALUED?THEPEAKOIL

BUBBLECHAPTER7-HowCrowds

Communicate

WHATDOINFORMATIONCASCADESTELLINVESTORS?THEROLEOFTHE

MASSMEDIAAWORDABOUT

PERSONALFLEXIBILITYANDTHEFUTUREOFMEDIAMONITORINGTHE

MARKETSSTUDYINGTHE

HISTORYOFBUBBLESANDCRASHES

CHAPTER8-ConstructingYourMediaDiary

GAININGTHEEDGEHOWMYDIARY

MADEADIFFERENCEIN2002

GETREADYTOCUTANDPASTEEXCERPTSFROMMY

MEDIADIARY:NOVEMBER2005EXCERPTSFROMMY

MEDIADIARY:JUNE2006INTERPRETING

MAGAZINECOVERSCHAPTER9-ImportantInvestmentThemes

TELLINGTHE

MARKET’SSTORYNEWERASEFFECTOFWAR

ANDINTERNATIONALPOLITICALCRISESONTHESTOCKMARKETFINANCIALCRISES

CREATECROWDSNEWINDUSTRIES

ANDCOMPANIESCOMMODITYBOOMS

INTERESTRATEMOVEMENTSANDTHEBONDMARKETUSINGYOURMEDIA

DIARYTOTRACKINVESTMENTTHEMES

CHAPTER10-InterpretingYourDiary:MarketSemiotics

MEDIAAND

INFORMATIONCASCADESYOURMEDIADIARY:

ALIVINGHISTORYOFINFORMATIONCASCADESSEMIOTICS:THE

STUDYOFSIGNSTHEMOST

IMPORTANTSIGN:THEPRICECHARTMAGAZINECOVER

STORIES

NEWSPAPERHEADLINESFRONTPAGE

STORIESANDEDITORIALSCRYSTALLIZING

EVENTSTHEWEIGHTOFTHE

EVIDENCEMOREONMARKET

SEMIOTICSCHAPTER11-TheGrand

StrategyofContrarianTrading

CONTRARIANINVESTMENTPLANNINGCONTRARIAN

TRADER’SINVESTMENTPORTFOLIOTHEINVESTMENT

GOALOFTHECONTRARIANTRADER

AWARNINGABOUTCAPITALGAINSTAXESCONTRARIAN

TRADINGSTRATEGY#1:DON’TSPECULATECONTRARIAN

TRADINGSTRATEGY#2:DON’TINVESTWITHTHECROWDCONTRARIAN

TRADINGSTRATEGY#3:CONTRARIANREBALANCING

THEAGGRESSIVECONTRARIANALONG-ONLY

STRATEGYFORTHEAGGRESSIVECONTRARIANTRADERMOREAGGRESSIVE

CONTRARIANTRADINGSTRATEGIES

CHAPTER12-TheGreatBullMarketof1982-2000

PROLOGUETHE1987CRASHINTERLUDE:THE

1929-1932CRASHANDBEARMARKETTHES&LCRISIS,THE

1987-1990BULLMARKET,ANDTHE1990BEARMARKETCROWDRALLYWITHOUT

JOY,1991-1994

THESTOCKMARKETBUBBLEINFLATES,1995-2000THEAGGRESSIVE

CONTRARIANFACESTHE1987CRASHTHE1990LOWLONGTERM

CAPITALMANAGEMENTGOESBUST

CHAPTER13-Collapseof

theBubble:The2000-2002BearMarket

ENDOFTHEGREATBULLMARKETCONTRARIAN

REBALANCINGDURINGTHE2000-2002BEARMARKETTHELONGWAY

DOWNAGAINCONTRARIAN

REBALANCING

DURINGTHECRASHTHEAGGRESSIVE

CONTRARIANDURINGTHE2000-2002BEARMARKETAWALLSTREET

WRECKTHESUMMER

RALLYTHEMARCH2001

PLUNGETERRORISTS

ATTACKON9/11

ENDOFABEARMARKETTRANSITIONTOA

NEWBULLMARKETCHAPTER14-ThePostbubbleBullMarketof2002-2007

ESCAPINGTHEBEAR’SCLAWWHATBULL?

LOOKINGFORSIGNSOFABULLISHINFORMATIONCASCADETHESTORYOF

GOOGLE’SIPOTHEHOUSING

BUBBLEAGGRESSIVE

CONTRARIANTRADINGDURINGTHE2002-2007BULLMARKET

APRIL2005—ABUYINGOPPORTUNITYJUNE2006—

ANOTHERBUYINGOPPORTUNITYAGGRESSIVE

CONTRARIANTRADINGINEARLY2007JULY-OCTOBER2007

CHAPTER15-ThePanicof2008

THECONSERVATIVE

CONTRARIANDURINGTHEPANICTHEMORTGAGE

MESSTHEDEBT-

DEFLATIONSPIRALTAKESHOLDLENDERSOFLAST

RESORTTHECREDITCRISIS

ANDTHE

CONTRARIANTRADERBULLMARKETTOP

ANDTHEFIRSTSTEPDOWNTHEBEARSTEARNS

FAILUREFANNIEAND

FREDDIETHECRASH:

BANKRUPTCYOFLEHMANBROTHERS

CHAPTER16-Vignetteson

ContrarianThoughtandPractice

THEPSYCHOLOGYOFTHESTOCKMARKETTHEGODFATHEROF

CONTRARYOPINIONOPINIONPOLLS:

WHATDOYOUTHINK?ISTHEODDLOTTER

ALWAYSWRONG?AFORECASTING

GIANTOFTHEPASTPAUL

MONTGOMERY,THEMAGAZINECOVERCONTRARIANIRRATIONAL

EXUBERANCEANDOTHERBUBBLESVALUEINVESTING—

ABACK-OF-THE-ENVELOPEAPPROACH

AbouttheAuthor

Index

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HG4515.15.F872009332.6—dc222008053438

Preface

Why is it so difficult to beatthestockmarket?Itiseasytosee that the market gives usplentyofchances tobuy lowandsellhigh.Justlookatthehistory of the past 10 years,1998 to 2008. During thattime the Standard & Poor’s

(S&P) 500 index hasfluctuated between 752 and1,565. There have been fivedistinct, substantial swingsacross this range. The briefpanicin1998arisingfromtheRussiancreditdefaultandthefailure of a big hedge fund,Long Term CapitalManagement, dropped theS&Pnearly 20 percent, from1,187 to 957. Those fearsquickly evaporated, and the

subsequent climb in pricescappedastockmarketbubblethatwasunprecedentedinthefinancialhistoryoftheUnitedStates. The S&P rose to ahighof1,527inMarch2000,an advance of nearly 1,400percent from its 1982 lowof102.

The biggest thrills of thisstock market roller-coasterride were yet to come. TheS&P dropped nearly 50

percent during the followingtwo years. At the index’sOctober 2002 low of 777,investors gasped at theshocking collapse of theInternetstocksandfearedthatcorporate accountingstatementsweremeaningless.But the downward rush instock prices during thepreceding two years seemedto generate just themomentum needed to push

themarketbackuptothetopof its next hill. During thesubsequent five years theS&Pmore than doubled to aclosinghigh inOctober2007of1,565.

As the stockmarketbeganto edge downward from its2007 peak, no one couldimagine the terrors that layahead. Within a year thepanic of 2008 had destroyedfinancial institutions around

the world. The rest teeteredon the edge of collapse. OnNovember20,2008,theS&Pclosed at 752 after careeningdownward52percentfromitshigh a year earlier. Manypeoplefearedthatevenworsewastocome.

InthisbookItellyouwhyit is so difficult for theaverage investor to profitfrom these roller-coasterswings in stock prices. I

explain why it is almostimpossible to consistentlybuy low and sell high andthus do better than thebenchmark strategy of thebuy-and-hold investor.Alongthe way I hope to help youmake an informed choice ofyour personal investmentstrategy.

You may decide thatattemptingtobeat themarketisnotreallyagoodchoicefor

you. The emotional straininvolved may just not beworth the effort. Self-knowledge like this isinvaluable, worth far morethanthepriceofthisbook.

Oryoumaychoosetolearnthe art of contrarian trading.Ifso,Ithinkyouhavechosena difficult path, but I alsothinkyouhaveinyourhandstheonlybookinprintthatcanhelpyouachievethisgoal.

I am a contrarian trader. Ihave learnedmy art the hardway, by making plenty ofmistakes, by unknowinglybecomingpartofthecrowdatthewrong time.Yousee, thereason stock prices move upanddownsomuchisthatweall like to joincrowds, socialgroupsoflike-mindedpeople.When such crowds formaround investing themes inthe stock market, they push

stock prices too high or toolow relative to fair value.Why? Crowds suppress thedissenting views ofnonmembers and amplify theconsensus views of theirmembers. Crowd membersact together, notindependently, andwhen thishappens the market pricestrays substantially from fairvalue.

Economic experts believe

that stock prices are muchmorevariable thanwarrantedby fluctuations in corporateprofits anddividends. I thinkthat the constant formationand disintegration ofinvestment crowds isresponsible for this excessivevariability and for the widerangeoverwhichstockpricestendtofluctuate.

Anotherwayofputtingthisis to say that investment

crowdsareresponsibleforthepricingmistakesmadebyMr.Market. Mr. Market is thesubject of an investmentparable told by the father ofvalue investing, BenjaminGraham. Mr. Market is atyour elbow each day tellingyou what he thinks yourinvestmentportfolioisworth.Many days his estimateseems plausible and justifiedby business conditions. On

many other daysMr.Marketlets his enthusiasm or fearsrun away with him, and thevalueheproposesseemslittleshort of silly. Investmentcrowds are responsible forMr. Market’s periodic boutsofenthusiasmorfear.

If investment crowds areresponsible for the pricingmistakes made by the stockmarket, then it logicallyfollowsthatyoucandobetter

than a buy-and-hold investorif you can detect thosesituations in which aninvestment crowd has drivena stock or the entire markettoohighortoolowrelativetofair value. The method fordoing this that I propose inthis book rests on a simpleobservation.

Crowds develop and growduring a communicationprocesscalledan information

cascade. During aninformation cascade the printand electronic media focuspublic attention on recent,dramatic movements inmarkets and the associatedprofits and losses ofinvestors. This in turnencourages people to putaside their natural skepticismand adopt the investmenttheme the media arehighlighting. As the

investment crowd thusgrowslarger, it pushes the marketeven further away from fairvalue and toward asubstantialvaluationmistake.

I think a contrarian tradercanlearntotakeadvantageofMr. Market’s periodic boutsof enthusiasm and fear bytrackinginformationcascadesinthemedia.Iwillshowyouhow to do this by keeping amediadiary.Inthefinalthird

of thisbook I’ll illustrate theuse of the contrarian trader’smedia diary during theturbulent years beginningwith the 1987 crash andcontinuing through the panicof2008.

Iwarnyouthatthejourneytowardbecomingacontrariantrader will be a difficult onewith an uncertain end. Mostpeoplearesimplynotcutoutto be contrarian traders, for

they love the companionshipand approval of their fellowinvestors too much. But ifyouarepreparedtostepawayfromthecrowd,tomakewiseinvestment choices that thecrowd will think silly or ill-advised, then thisbook is foryou. You may also want tofollow my contrarian tradingviews in real time. For theseyou can look to my blog,whichcurrentlycanbefound

atwww.carlfutia.blogspot.com.

Each of the following 16chapters begins with a briefoutline of its content. Here Iwant only to give you ageneralpictureofthisbook’sstructure and the way inwhich it explains the processofcontrariantrading.

Chapters1to5developthefoundation on which our

methodwill rest.We answerthe question of why somespeculatorswinbutmostlose,and in so doing we identifythe successful speculator’scharacteristic edge. We willsee why investment crowdsare responsible for marketmistakes and discuss thecharacteristic behavior ofsuchcrowds.

Chapters6 to11 explain apractical approach to

contrarian trading. Here welearn about the contrariantrader’s principal tool, hismedia diary. We discoverhow the informationcontained in a media diarycan be interpreted and thencoordinated with a statisticalview of a market’s currentand past swings. We alsodevelop specific contrariantrading strategies, one for aconservative and another for

an aggressive contrariantrader.

In Chapters 12 to 15 weapply the techniquesexplained in the precedingchapterstothestockmarket.Ikept my ownmedia diary inreal time during the years1987to2008.Ithinkyouwillbe surprised to see howeffectively it identified themany valuation mistakes thestock market made during

thoseyears.

Chapter 16 contains asmall number of very briefessays and notes I wrote formy own benefit as I learnedto be a contrarian trader. Itexplains the development ofthe theory of contraryopinion, highlights thecontributions key individualsmade to the theory,discussesbriefly several books everycontrarian should read, and

offers comments on back-of-the-envelope value investingforthecontrariantrader.

You will notice that thisbook contains not a singlestockmarketchart.Thereisagood reason for this. Whenyouseeachartaccompanyingan explanation of a stockmarket technique, you alsogenerallyalsoseehowthingsturned out. This makes theresult of a good investment

decision seem inevitable andobvious. But every real-lifedecision is made underconditions of greatuncertainty,atatimewhenitis not at all obvious whetheryour choice will yield asubsequent profit or insteadyielda loss.Toconveymoreof the feeling of uncertaintythat accompanies realinvestment decisions, I havechosentofocusattentiononly

on the facts that could beknown at the time theinvestment choicewasmade.This isbestdonewithout theuseofchartsasillustrations.

There is another reason toexclude charts from thediscussion. When presentedwithachart,thehumaneyeisnaturally drawn to its salientfeatures. For a stock marketchart these are usually thehighandlowpointsofprices.

Butoneimportantmessageofthis book is that thecontrarian trader isnot in thebusiness of predicting stockmarket highs and lows or ofmaking correct forecasts ofanykind.Insteadhisfocusison a single objective, that ofachievingahigherreturnthanthat earned by the buy-and-holdstrategy.Hedoesthisbyadopting an investmentstrategythatleansagainstthe

crowd. This does not requirehimtobuynearlowpointsorsellnearhighpointsinprices.It only demands that hisaverage selling price exceedshis average buying price byan amount sufficient tocompensate for risk and forthetimevalueofmoney.

Writingthisbookhasbeenan adventure and a pleasure.If you can take from it evenone idea that improves your

investment results, then Ishall be doubly rewarded.Now let us begin ouruncertainjourney.

CARLFUTIA

November26,2008

CHAPTER1

CanYouBeattheMarket?

The speculator’s edge• traits needed for anedge•therightstuff•markets need

speculators • lendinga helping hand • fairvalue • marketmistakes •uncoveringmistakes • corporateprofitsandfairvalue•statistical models forprofit forecasting •such models areuseless • investorsdon’t live in LakeWobegon • evidencefrom mutual fund

performance •technicalanalysisandmarket timing won’tgiveyouanedge•thecatch-22ofinvesting•the No Free Lunchprinciple • the art ofspeculation • mostpeople should notspeculate • but if youhave the right stuff,readon!

THESPECULATOR’S

EDGE

Canyoubeatthemarket?I’mgoing to do my best toconvinceyou that theanswerto this question is no. Thissurely isanovelway to startabookabout speculation!Ofcourse the name of the

speculative game is beatingthemarket.And, yes, Iwantyou to read this book aboutbeating the market fromcover to cover and tell allyour friends to do the same.But I also want you to readthesechapterswithyoureyeswideopentothedangersandpitfalls of speculation. Thereisnoeasymoneywaitingforyou in the financial markets.Sohere, rightupfront, is the

most important thing I havetosaytoyou:Don’tspeculateunlessyouaresureyouhaveanedge.Withoutanedgeyoucan’tbeatthemarket.

What do I mean by anedge?An edge is a talent orskill or some specificknowledge thatwillgiveyouan advantage over otherinvestorsandspeculators.Sadto say, a high IQ, greateducational credentials, or a

substantial net worth are notedges in the game ofspeculation. Neither is thewillingness toworkhardandto keep trying after repeatedfailures. These things maymake you a success in yourprofession or trade and avalued member of yourcommunity. But they won’tguarantee you success in theworldofspeculation.

You should know that the

biggest part of anyspeculator’s edge does notcome from a superiorscientific or statisticalknowledge of marketbehavior. If it did, youcouldbuildyouredgethesamewayyou acquire skills in anyprofession—by study andpractice. But have younoticed that no college oruniversity offers a major inspeculation? There is a good

reasonforthis.Aspeculator’sedgearisesfromtwopersonaltraits thatcan’tbetaughtandthat people either have ordon’t have. The first isflexibility ofmind and spirit,theabilitytoadapteasilyandquickly to changes inmarketconditions and habits. Thesecond is the willingness tothink for oneself and to riskhard-earned money by“fading” (investing opposite

to) popular opinion. Thismeans that you will usuallytake market positions thatmostpeople(yourhusbandorwife especially!) will see asunwiseorevenfoolish.Doingthis day in and day outrequires emotional toughnessthatfewpeoplecanmuster.Italso requires a certainarrogance—a firmconvictionthat you know what you aredoing and that most other

people in the market don’t.Doyouhavetherightstufftobeasuccessfulspeculator?

I think youwill agree thatthisisanunusualexplanationof the nature of thespeculator’s edge. In ourtechnological society, it’snatural for people to believethat speculative profits arisefrom the use of superiormethodsorfromsomearcaneknowledge of market

behavior. But this isn’t true.The essence of successfulspeculation cannot be foundin specialized knowledge ofmarketbehaviororoftradingtechnique.Youcan’t learn tobea successful speculatorbyreading books (this oneincluded!),bytakingcourses,orbyattendingseminars.

However, if you do havethe right stuff to be aspeculator, then you can

move your game to a higherlevelbyapplyingthemethodsI explain in the followingchapters. The financialmarkets need skilledspeculators. Capitalismcouldn’t survive withoutthem. To see why, just keepreading.

LENDINGA

HELPINGHANDTOINVESTORS

Whatisaspeculator?Whatishis mission on capitalism’sbattlefield of creativedestruction?Lewis andShort(my always-at-hand Latindictionary) defines the verbspeculor tomean “the actionof watching, observing,examiningorexploring.”Soa

speculator is a lookout, ascout, an explorer, and aninvestigator.

A financial speculatorexplores the terrain ahead ofthe army of long-terminvestors. This army isadvancing toward a veryuncertain future, aconsequence of JosephSchumpeter’s perennial galeof creative destruction ,which always accompanies

the development of acapitalist economy. Long-term investors must beassured of being able to buyand sell at a fair price, andthis despite the enormousuncertainty that is incapitalism’s very nature. Iflong-term investors believethatmarketswon’tgivethemafairshake,theywilllockuptheir investment capital, andthe machinery of capitalism

would then grind to animpoverishinghalt.

Howdoesaspeculatorhelpensure that long-terminvestors get a fair shake?Every speculator is on thelookout for mistakes themarkethasmade inpricingastock,bond,orcommodity.Amarketmistake is a situationwherethecurrentmarketfailstoaccuratelyreflectallthatisknown about the probable

earning power of thecompany or the supply-demand balance for thecommodity. A speculatorprofits by spotting marketmistakes and helping tocorrect thembybuyingwhenthe price is too low andsellingwhenitistoohigh.

A market mistake is adeviation from the fair valueprice.Thephrasefairvalueisa plain-and-simple term for

what economists call theequilibrium price (i.e., theprice that will equate supplywith demand). Economicsteaches that the equilibriumpriceisanaccuratereflectionof what is known about theprospects of the stock orcommodity in question. Assuch, theequilibriumprice isa very good thing. Peoplewho buy or sell at theequilibrium price are getting

afairshake;theyaren’tbeingunfairly exploited by moreknowledgeableinvestors.

Itisimportanttorememberthat the conceptof fair valuecan be difficult to pin down.Inthenextchapterwebrieflydiscuss one method forcalculating fair value:discounted future dividends.In Chapter 5 we discussanother: the q ratio, firstdeveloped by the economist

James Tobin. Both of thesemethodsaredesigned togivevery long-term, multiyearestimates of the fair valueprice. But generally bothmethods are too unwieldy tobe of much use to aprofessional speculator. Wediscuss more practical waysto estimate fair value inChapter6.

It should come as nosurprise that markets make

mistakes. Usually thesemistakesareonlyshort-lived,minorones,butonoccasionamarket makes a really big,long-lasting mistake.Mistakescantaketheformofa shortsighted reaction to asurprising corporate oreconomic development. Or amistakecanarisebecauseofamass delusion or mania. Ineither case, the price of thestockorcommodity rises too

high or falls too low relativeto any reasonable assessmentoffairvalue.

A speculator’s economicfunction is to be on thelookout for these marketmistakes and to help correctthem.Hedoesthisbybuyingwhen the price is below fairvalue and by selling when itis above. The speculator’sbuyingandselling thushelpsto nudge the market price

closer to fair value. In thisway speculators perform avaluable service for longer-term investors. They helpensure that market pricesmore often andmore closelyreflect the best possibleassessment of futureeconomicprospects.

UNCOVERING

MARKETMISTAKES

Howdoes a speculator knowthat the market is making amistake?Youcanbesurethatthere is no neon sign to thateffect posted in front of thestock exchange. You won’tsee “XYZ ON SALETODAY” or “ABC NOTWORTH AN ARM AND A

LEG” running across themessage board at 42nd andBroadwayinNewYorkCity.

Most investors approachthe problem of identifyingmarket mistakes from aneconomic and statisticalperspective. Basic economicconsiderations suggest thatthe fair value price for acompany’s stock should bedetermined by discounting tothe present the profits the

company is likely to earnover some reasonable timeinterval, say 10 years. Youcan try to estimate of theseprofits by modeling theindustry and the economyusing state-of-the-artstatisticalandeconomictools.Or you could buy thisinformation from someonewhocandothismodelingforyou. In either case thisprofitestimate will determine an

estimate of the fair valueprice for the stock.Detectingamarketmistake is then justa matter of comparing thisestimate of the fair valuepricewith thecurrentmarketprice.

This certainly is a logicalapproach to the problem ofuncovering market mistakes,at least in the stock market.Economistsagreethatthefairvalue for a corporation’s

common stock is the pricethat reflects all theinformation currentlyavailable about thecompany’s future earningpower, dividends, generaleconomic conditions—everything that might berelevant to estimating thelikely future dividends andcapital gains an investorcould expect. Investors whoadopt this approach will

purchase stocks that aretrading below their estimatesoffairvalueandsellstocksifthey are trading above suchestimates. Here is the keyquestion: Is there any reasontobelievethatthismethodfordetecting market mistakeswillallowaninvestortoearnabove-averagereturns?

You may find my answerto this question shocking. Ibelievethatitisimpossibleto

earnabove-averagereturnsonyour investment portfolio byusing statistical estimates ofeconomic fair value. Why?Well, the key phrase isabove-average returns. Onecan certainly use statisticaland business knowledge toconstruct models forestimating fair value of acommon stock that havesome reliability. But youmust keep in mind that

speculation is a verycompetitive business. Manyinvestors, money managers,andeconomicconsultantsaredoing this same thing. Theyare all competing for theprofits that can be earned bymaking superior estimates ofastock’sfairvalueprice.

Sadly, unlike the childrenof Lake Wobegon, who areall above average, investorscannot all achieve above-

average investment results.Rememberthatlotsofpeoplehave the knowledge andstatisticalskills tobuildgoodcorporate earningsforecasting models. Ifbuilding such models led tosuperior investment results,people would rush in andadopt this methodology. Butby doing so they wouldcollectively move marketpricesinthedirectionoftheir

fair value estimates. Thiswould narrow the deviationof the market price from thefair value estimates to thepoint where this investmenttechnique would yield onlyaverage results. There is somuch competition amongmodel builders and theinvestors who pay for thesemodels’ forecasts thatneithergroupcanearnabove-averagereturns, either by building

models or by using theforecasts themodels produceto guide their investmentstrategy!

LOOKINGATTHEEVIDENCE

Perhaps I have alreadyconvinced you thatcompetitionmakes it hard to

speculate successfully bydoing corporate profitmodeling. But if not, youmight counter by saying thattheworldinwhichweliveisnothing like the freelycompetitive world oftheoretical economics.Perhaps all that is needed istobuildthebettermousetrap,the super-duper, high-techprofit-forecasting model thatwillbeatallothers to thepot

of gold. I think there is verygoodreasontobeskepticalofthis possibility. If resourcesand technical skills wouldguarantee success in thebattle for investment profits,we should find thatinvestment professionals,those who ought to haveaccess to the best profit-forecasting models, producebetter than averageinvestment results. So let’s

look at the actual investmentresults achieved byprofessionalmoneymanagerstoseeifthisistrue.

In a 2005 article in theFinancial Review,“Reflections on the EfficientMarketHypothesis:30YearsLater,” volume 40, pp. 1-9,BurtonMalkiel examined theperformance of professionalmoney managers in theUnited States and other

developedcountries.Hisdataon mutual fund performancereveal three important facts.First, most actively managedstock market mutual fundsunderperform theirbenchmark index, theStandard & Poor’s (S&P)500. Over a single-year timespan, 73 percent do worsethan the index, and thispercentage increases to 90percent if one considers

performance over a 20-yeartime span. Second, passivelymanaged S&P 500 indexfunds do about 2 percentbetter per year than doactively managed stockmarketmutualfunds.Mostofthis difference is accountedforbythehigherfeesactivelymanagedmutualfundschargetheir shareholders. Finally,there is little consistencyfrom year to year in

performance relative to thebenchmark by any givenmutual fund. So it isimpossible to tell in advancewhich mutual funds will dobetter than the benchmarkusing only their pastperformanceasaguide.

Malkiel’s conclusions aretypical of those reached byfinancial economists whenthey examine theperformances of professional

money managers. From thisbody of research I think wemust conclude that modelsthat estimate fair value usingeconomic and business datawill not give you anyadvantage over otherinvestors. If they did, wewould expect to see above-average investmentperformance by stockmarketmutual funds, because theirmanagers have access to the

bestearningsforecastmodels.We would also expect suchmarket-beating performanceto persist from year to yearfor specific mutual funds,because it is themutual fundmanagement firm that paysfor the models and thesemodelswouldbeavailabletoany manager who works forthemanagementfirm.

But we see none of thesethings. The conclusion to be

drawn from this evidence issimple enough. If you aretryingtoidentifythemarket’smistakes by using statisticalmodels to estimate futureprofits, you are barking upthe wrong tree. Models thatforecast corporate profitscan’t help you beat themarket, because everyoneuses them.Afterall, this sortof approach to stock marketvaluation is taught in every

businessschool.Howcoulditgive you a chance to earnabove-average returns ifevery professional moneymanagerknowsandusesit?

MARKETTIMING

There is an even morestriking conclusion to bedrawn from the persistent

underperformance of mutualfund money managers as agroup. The logic that leadsone to conclude thatstatistical forecasting modelsthat forecastcorporateprofitscan’t be used to achievemarket-beating investmentperformance has to apply tootherapproachesaswell.

This broader category ofessentially valuelessmethodologies includes what

are popularly known astechnicalanalysisandmarkettiming. The idea behindtechnical analysis is that amarket’s price action revealsto the careful observer whatother investors have learnedaboutfairvalue.Forexample,investors who estimate fairvalue using economic andbusiness data (so-calledfundamentalist investors)reveal these estimates to the

watchful and skilled markettechnicianviathebuyingandselling they do to takeadvantage of their models’estimates. In this way amarkettechnicianbelieveshecan piggyback his analysisupon the efforts of thefundamentalist investors.When he does this, heamplifies the effects offundamentalists’buyand selldecisions.

In the standard technicalanalyst tool kit one findsvarious forms of price chartinterpretation, momentumand moving average tradingstrategies, and overbought-oversold oscillator methods.These tools are too widelyknown and studied to helpyou earn above-averagereturns on your investments.Any advantage they mightconfer is soon competed

away in the profit-seekingrush of technical analysts toadopt them. Of course onecannotruleoutthepossibilitythat therearemarket-beatingtechnical methods. One canonlydeducethatyouwillnotreadabouttheminabook!

Amarkettimerissomeonewho attempts to beat themarket by predicting theswingsinmarketpricesaheadof time and acting on these

predictions. Technicalanalysis typically plays a bigrole in most market timers’decision processes. Butmarket timing is ingeneral afruitlessactivity for thesamereason that technical analysisfails.

Thinkaboutmarket timinglike this. If amarket timer isto be successful he must berighttwiceinarow—hemustfirst buy low and then sell

high. So let’s suppose ourhypothetical market timer isquite skilled and hasdeveloped a method thatpredicts and takes advantageofthedirectionofamarket’supcomingmove70percentofthe time (most methods Ihaveseendon’tcomeclosetothis success rate). Theprobability that this markettimerisrighttwoconsecutivetimes is .70 × .70 = .49. So

even if his method guessesright 70 percent of the time,only 49 percent of the timewill he improve his positionover the alternative of doingnothing. For this reason theoddsarethatamarkettimer’sefforts will simply make hisportfolio more volatilewithout increasing hisaverage returns. Even askilledmarkettimerwillhavedifficultybeatingthemarket.

CATCH-22

We have just encounteredwhat I call the catch-22 ofinvesting: Any statisticalmethodology that directly(fundamentalist approach) orindirectly (technical analysisapproach)estimatesfairvalueandthatiswidelyusedcannothelp you beat the market.Economists call this the No

Free Lunch principle.Competition among investorsleads to a situation in whichknowledge in the publicdomain can’t lead to above-average investment returns.There is no information youcan find in a book oninvesting or trading (this oneincluded!)oryoucanlearnatan investment seminar thatwill by itself help you dobetterthanthemarket.Notice

that this alsomeans that it iseven impossible for you, anaverage investor, to purchasesuperior investmentperformance by entrustingyourmoney toaprofessionalmoneymanager.

SowheredoestheNoFreeLunch principle leave us?One thing seems obvious.Developing an edge overother investorscannotsimplybe a matter of reading some

books, getting a goodeducation, or having a highIQ. An edge cannot arisefrom mastery of statisticaland analytical skills you canlearn from books or inbusiness school courses. Thereason is simple: Lots ofpeople do this, andwhat lotsofpeopledowon’tmakeyouanabove-averageinvestor.

I think that to develop anedge you must start by

abandoning preconceivedideas.Youaremakingagoodstartifyouhavereadthisfar.You must learn to besuspiciousofpopularopinionand conventional wisdom.Indeed, the entire art ofspeculation consists ofchoosingtherightmomenttoinvest in a way opposite tothat suggested by popularopinion. An edge can befoundonlybylivingbyone’s

wits in a world wheresurvival and prosperity aredaily question marks. I haveseen firsthand thatmaintainingthiskindofedgeextracts an emotional andmental toll that very fewpeople can pay. For the vastmajority, an investment edgeis just notworth the effort ittakestoacquireandmaintainit.Itmakesnosenseformostpeople to speculate in the

financialmarkets.

Well, I havedonemybestto convince you that youshould not speculate. But ifyou still think you have therightstuff,youwillfindalotof useful information andsuggestionsintherestof thisbook. I’ll try to explainwhatyou must do to hone yourspeculative skills. I cansummarizemymessage verysimply: Become a

professionalcontrarian!

CHAPTER2

MarketMistakes

Efficient markets?not! • markets makemistakes • “no freelunch” means thatmistakes are hard to

identify • rollercoasters and stockmarkets • do stockprices fluctuate toomuch? • Shiller’swork on stock marketvolatility • efficientmarkets theory can’texplain volatility •behavioral finance •why might marketmistakespersist?•theunknown unknown •

the lastone toknow •the lunatic factor •markets do not makesystematic mistakes •Fama’s work • NoFree Lunch redux •lookingfortheedge

EFFICIENTMARKETS

InChapter1 I explained thata speculator’s job is todiscovermarketmistakesandthenhelptonudgethemarketprice back to fair value. Iboldly asserted that marketsmake lots of mistakes. Butyou should know that thereare respected theories infinancial economics thatassert that markets nevermake mistakes. Thesetheories say that markets are

strongly efficient, that atevery moment the marketaccuratelyreflectsallthatcanbe deduced from economicanalysisand technicalmarketmethods about today’s fairvaluemarketprice.

If markets really wereefficient in this strong sense,there would be no room forspeculators to make a profit.In this chapter I want toexplain why I think markets

arenotefficientinthisstrongsense.Iwanttoarguethat,asa matter of fact and notopinion, markets rarely tradeat the fair value, economicequilibrium price. I want toconvince you that at least inprinciple there are manyopportunities for speculatorstomake a profit. To do this,we’ll have to take a closelook at the reasons marketsspend extended periods of

time trading well above orwell below fair value. Thisinvestigation will carry usinto the realm of behavioralfinance, investor sentiment,andcrowdbehavior.Tokeepthings simple, I am going tofocus on the mistakes madeby markets for commonstocks in the United States,althoughallfinancialmarketsworldwide are mistake-proneaswell.

Keep in mind that the NoFree Lunch principle tells usthatmarketsdonotmakelotsof statistically exploitablemistakes. In other words,financial markets’ mistakesshow no statisticalregularities and can be usedto predict and identify thesemistakes as they arehappening. The reason forthisbearsrepeating:Therearelarge numbers of speculators

and investors on the lookoutformarketmistakes,andtheyare willing to use anyplausiblestatisticalmethodtouncover these mistakes.Competition amongspeculators will reduce thereturns earned by theirstatistical methodologies tothereturnsearnedbythebuy-and-hold strategy. The NoFreeLunchprinciplepredictsthat every mistake a market

makes will be a surprise atthe time it is happening. Tothevastmajorityofinvestors,market mistakes will bevisible only in hindsight. Somarketmistakeswill be veryhard to detect and exploit atthe time they occur. Sadly, aspeculator cannot profit from20/20 hindsight, so the NoFree Lunch principle istelling us that successfulspeculatorsareararebreed—

people who have skills andcharacteristics that cannot betaughtoreasilydiscovered.Itis my thesis that thesuccessful speculator’s edgerests on his ability to standapart from the crowd and toact opposite to the crowd’sbeliefsandexpectations.

ROLLER

COASTERSANDSTOCKMARKETS

When the financier JohnPierpontMorgan(1837-1913)was asked for his stockmarket forecast he replied,“Stockswillfluctuate.”Thereis more wisdom in his replythan meets the eye. Morganunderstood the implicationsof the No Free Lunch

principle,becausehemadenoattempttopredictwhetherthestock market was about tomove higher or lower. Hespoke as if he believed thatall the factors that mightinfluence the market’smovements were alreadyreflected in the level ofcurrent prices. Future pricechanges would therefore beresponses to new andcurrently unknowable

information. But he alsoemphasizedthatstockswould“fluctuate.”Weshallsoonseethat this is an enduringcharacteristic of the stockmarket, and indeed of allfinancialmarkets.

Do you have fun ridingroller coasters? Frankly, theyarenotmycupoftea,butmychildren love them. I thinkstock markets are a lot likeroller coasters. Prices always

seem tobe inmotion—upordown. At the start of a bullmarket, stock prices, like thestartofarollercoaster’sride,move slowly but steadilyhigher. They seem to beclimbing a steep hill pulledby improvements inunderlying economicconditions and corporateprofits.Asthemarketreachesthetopofthehill,itsadvanceslows, flattens out, and then

prices gradually soften. Soonthe market is hurtlingdownhill as if pulled bygravity, its riders screamingin panic. Fear replacesoptimism, but just when thestock prices appear ready toplunge to zero and economicdepression seems imminent,themarketspringsupward.Itisasiftheverymomentumofthe previous stomach-churning drop has combined

with an invisible turn of thetrack to push prices higheronce more. The path to thenextbullmarketpeakwillnodoubttakethemarketthroughseveral hair-raising twists,turns, and loops. It will belots of fun, but everyoneknows that another terrifyingdrop lies dead ahead. Its allpart of the roller-coasterexperience.

Imagine having to ride a

roller coaster whenever youhad to travel to work fromhome.Howwouldyoufeelifa roller coaster was the onlyavailable mode oftransportation you had? Isupposeyoucouldgetusedtoit.Butyouwouldbetravelingmany more miles (many ofthem in the verticaldirection!) than you do nowin your car. Not only wouldyour travel times lengthen,

but (at least for me) justgetting to the grocery storewould be a nerve-rackingexperience.

Investors have no choicebut to ride the market rollercoaster. Its ups and downsseem designed to defeat allbut those with the strongeststomachs. And, just like aroller coaster, the market’smovements are in a certainsense artificial.At least from

an economic perspective,they are not justified by upsand downs in underlyingeconomic conditions andcorporateprofits.Insteadtheyreflect something that seemsinherent intheverynatureofthe process that pricescorporateassets.

Professor Robert J. Shilleris among the word’s expertsinthestudyofthebehaviorofspeculative markets. In

March 2000, with anexquisite sense of markettiming in the publishingworld, thebookforwhichheis justifiably famous,Irrational Exuberance(Princeton University Press),shook the world of WallStreet. In it Shiller arguedthat the great stock marketboomthathadstartedin1982wasdisplayingallthesignsofabubble, thatevery indicator

of economic value showedthat investors wereirrationally exuberant. Theywere placing unreasonablyhigh valuations onprospective corporate profitsand dividends. We all knowwhat happened next. InMarch 2000 the S&P 500began a drop that eventuallycarriedit50percentlowerbyOctober2002.TheNASDAQCompositeindex,hometothe

Internet and technologyhighfliers of 1998-2000,dropped80percentduringthesametime.Somefluctuation!

Yet the bull market of1982-2000 and the ensuingthree-year bear market wereby no means unprecedentedevents, as Shiller shows inIrrational Exuberance. He isinapositiontoknow.Indeed,Professor Shiller’s entirecareer had been devoted to

the study of speculativemarkets and to investigatingwhether market fluctuationsare in any sense determinedand justified by economicdevelopments andchanges incorporate profits. The resultsof his investigations werepublished 11 years earlier inhis book Market Volatility(MIT Press, 1989). Theyprovide importantinformation about the

frequency and extent of thestockmarket’smistakes.

DOSTOCKPRICESFLUCTUATETOO

MUCH?

In Chapter 4 of MarketVolatility Shiller adopted thestandardeconomichypothesis

fordeterminingthefairvalueofthestockmarket.Thissaysthat the long-term fair valueprice for the Standard &Poor’s Composite 500 stockmarketindexshouldbetakento be the present discountedvalue of future dividendpayouts. This standardapproach to asset valuationwould apply not just tocommon stocks but to anyother asset (e.g., bonds, real

estate.etc.)thatisexpectedtoyield a regular sequence ofcash payouts over theforeseeablefuture.Ofcourse,at any point in time onedoesn’t actually know whatthesefuturedividendswillbe,say over the next 30 years,butShiller’seconomicmodelassumes that you do. Youmight object that such anassumption is ridiculous onits face. But it turns out that

the discounted stream ofdividends is very predicableand grows at a nearlyconstantrate.SointhissenseShiller’s “perfect foresight”assumption is a reasonableonebecausedividendpayoutsfor the stock market as awholearequitepredictable.

Havingthisestimateofthestock market’s fair valueprice in hand, Shiller thencompares it with the actual

level of the S&P Composite500 index. Both thesenumberschangefromyeartoyear, and Shiller comparesthe variability of the S&PCompositeovertimewiththevariability of the discountedstream of futures dividends.Hefindsthatpricesareinthelong run about four times asvolatile as the discountedstream of dividends.Moreover, the correlation

between the changes in thelevel of the S&P Compositeindex and the changes in thevalue of the long-run streamofdividendsisverylow.Thisis surprising, at least toeconomists.Efficientmarketstheory predicts that stockmarket prices should showless variability thandiscounted dividends, andthat changes in stock marketprices should be highly

correlatedwithchangesinthediscounted value ofdividends.

What should we make ofthese facts? At an intuitivelevel at least, most investorswould find Shiller’sconclusions unsurprising.Indeed, they might marvelthat anyone would suggestthat the discounted streamoffuture dividends shoulddetermine fair value in the

stock market. “After all,”theywould say, “we care farmore about earnings growththan dividend payouts, andour profit forecastingmodelstake this difference intoaccount.”Butsucharesponsemisses the point. The fact isthat economy-wide earningsand economy-wide dividendsmove in lockstep over time.True,anyindividualcompanymay be seen as a “growth

opportunity” or as a “steadydividendpayer”byindividualinvestors, but this is adistinction without adifference when looking atthe economy as a whole andwhentryingtounderstandthesourceofpricefluctuationsintheS&PComposite index. Ifstock prices are notdetermined by the long-rundividends and earningsgenerated by corporations in

theU.S.economy,whatdoesdetermine them? In thissituation I believe that thesage of Omaha, WarrenBuffett, would accept thebroad outline of Shiller’sapproach. Buffett has oftenquoted Benjamin Graham’ssaying that in the short runthe stock market is a votingmachine,butinthelongrunitis a weighing machine. Bythis he means that the value

of a company’s commonstock is determined in thelong run by the company’sabilitytoearnprofitsandpayout dividends to itsshareholders.

Some economists havecriticized Shiller’scalculationsbyobservingthatthegrowthofdividendsfromyear to year is betterdescribed as a random walkthan as a process that

fluctuates around a knowntrend. If this is true, onewouldingeneralexpectmorevolatility in stockprices thanShiller’s model wouldpredict. (In technical termsthese economists are sayingthat theseriesofdividendsisnot stationary, contrary toShiller’s assumption.) But itturnsout thatevenwhen thisdifferent statistical model ofthe behavior of dividends is

adopted, the stockprices stillfluctuatefartoomuchrelativeto long-run dividendfluctuations.

The basic conclusion ofShiller’s research is that theefficient markets model doesnot do well in explainingstock market volatility. Thisno doubt cheers investorswho have grown weary ofeconomists’ employingefficient markets theory as a

club to beat them intoacceptingthefutilityoftryingtobeat themarket. It isclearfrom Shiller’s data that thestock market as a wholemakes lots of mistakes—theS&P Composite indexfluctuates in a wide rangearoundfairvalueasmeasuredby discounted futuredividends. But those whowould take satisfaction fromthis defeat of the efficient

markets theory should bewary. The No Free Lunchphenomenon still rules theinvestment world. Stockmarkets may indeed makemany mistakes, but it isgenerally impossible torecognize these mistakeswhen they occur! But mightthinking outside the box ofstandard financial theory andlooking at different sorts ofdata help us identify and

exploit the mistakes of thesortShillerdetected?

ALOOKATBEHAVIORALFINANCE

To answer this last questionwehaveto takea lookat thereasons stock market prices

mightdeviatefromfairvalue.This will take us into therealm of what is known asbehavioral finance, a branchof economics. Classicaleconomics studies thebehaviorofmarketsinwhichpeople buy and sell using alltheinformationtheyhaveinastatistically appropriate way.But what if humanpsychology or computationallimitations prevents this?

What if a significant numberof investors, for whateverreason,failtouseinformationavailable to them correctly?How would this affect thebehaviorofthestockmarket?Must it inevitably cause themarket to make mistakes?Behavioral economicsaddresses these sorts ofquestions.

Richard Thaler is aprofessorat theUniversityof

Chicago and a widelyrecognized expert inbehavioral finance. Togetherwith his co-author, NicholasBarbaris, Thaler wrote arecent survey of behavioralfinance that appears asChapter 1 in Advances inBehavioral Finance, Volume2 (Richard Thaler, ed.;Princeton University Press,2005). Thaler and Barbarisdiscussthemanyreasonswhy

investors mightpsychologically be unable tomake good statistical use ofthe information they have.Indeed, they point to theample experimental evidenceshowing that this is apervasive phenomenon, thatpeople fail to use a soundstatistical approach whenmaking choices underuncertainty.

However, as Barbaris and

Thalerpointout,thefactthata segment of the investorpopulationacts irrationally inthis sense does notnecessarily imply thatmarketsmakemistakes.Afterall, if some people makestatistical errors andconsequently drive the priceof a stock away from its fairvalue price, shouldn’t arational investor be able totake advantage of this

mistake by taking theopposite action and profitingas the price returns to fairvalue?

To this question thebehavioraleconomistanswers“perhaps,” but the classicaleconomist answers “always.”Here lies the essentialdifferencebetweenbehavioraltheories of financial marketsand the classical efficientmarkets hypothesis. Let’s

examine the reasons whyrational investors might notbe able to correct themistakes made by irrationalinvestors.

Every trading andinvestment strategy has itsassociated costs and risks.Costs arise from the processof buying and selling itself(brokeragecommissions,bid-ask spreads, etc.) as well asfromtheexpenseofgathering

and processing informationcorrectly.Risksarisefromtheusualuncertainties associatedwith asset pricing as well asfrom institutional factorsresulting from the waymarkets are organized. Asimple example of this isshort selling. If a rationalinvestor recognizes that astock is selling above its fairmarketpriceandhewants toparticipate in this selling, he

may not be able to sell thestock if he does not alreadyown it. To do so he mustborrow the shares from awilling lender, and this notonly requires the cooperationof two parties but thepayment of interest on theloanoftheshares.Moreover,the market for borrowingthesesharesmaybeverythinand may expose the shortseller to added risk of a

squeeze by the lender. Thus,even if the shares can beborrowed, thecostsand risksof short selling are notsymmetrically placed withthose of buying the stock inquestion. For this reasonalone, one might expect thestock market to be moreprone to make mistakes ofovervaluation than ofundervaluation.

But there are three other

kinds of risk associated withattempts to correct marketmistakes—risks that arerarely considered, probablybecause experiencedspeculators don’t usually puttheirthoughtsonpaper.

The first is the risk of theunknown unknown. This isjust a snappy way ofdescribing what theeconomist Frank Knightcalleduncertaintyinhis1921

book Risk, Uncertainty, andProfit.Knightianuncertainty,nowadays calledunquantifiable risk, is asituation inwhichwe cannoteven imagine the things wedon’t know (hence the termunknown unknown). Andevenifwecanimaginethem,we have no way to attachprobabilitiestothem.Agoodexample of Knightianuncertainty developed during

the panic of 2008 marketturmoil arising from thesubprimelendingmess.We’lldiscussthisepisodeingreaterdetail later. For now I justwant topointout thatnoonethen had a grip on just howmuchtoxicwaste(atechnicalterm used by financial typestodescribeassets that cannotbe sold) was to be found onthe balance sheets of anumber of big banks and

brokerage firms, nor on howsuch securities could bevalued. Consequently, themarkets for all kinds ofsecurities took a tumble andbuyerswerehardtofind—allbecause no one could evenestimate the magnitude of aproblemthathadneverarisenbefore. This is a classic caseofthedangeroftheunknownunknown.

The second kind of risk I

like to call “the last one toknow” risk. When I think amarket is making a mistake,thefirstthoughtthatcomestomy mind is: “What if otherpeople know something Idon’t?” My experience hasbeen that every investor hasthesamefearofbeingthelasttoknow.Wewillseethatthisplays an important role incausing markets to makemistakes.Itcertainlymakesit

difficult for the averageinvestor to play any role incorrecting these samemistakes.

The third risk is just assignificant as the other two,perhapsmoreso.ItistheriskassociatedwithwhatIcallthelunatic factor. Years ofexperiencehavetaughtmetoask, upon seeing what lookslike a market mistake,whether the lunatics have

taken over the asylum. It isimportant never tounderestimate the buying orselling power of a crowd ofmarket lunatics who areacting under the influence ofsome financial delusion oremotion, whether greed or(morecommonly)fear.Whenthe lunatics take over themarket asylum, any marketmistakecanandprobablywillget a lot worse before it is

corrected.Insuchasituation,rational calculation ofunderlying economic factorsmust yield to attempts tooutguess the thinkingprocessesandbehaviorofthelunatics. In suchcircumstances the marketprice can be nearlyindeterminate, and the risksinherent in attempting tocorrect market mistakes areinordinatelyhigh.

We see then that there arecosts and risks associatedwith the effort to correct amarket mistake. If these aresubstantial, we would expectthe mistake to persist andeven get worse before it iscorrected.

BEHAVIORALFINANCEAND

EXPLOITABLEMARKETMISTAKES

Behavioral finance gives usreasontobelievethatmarketscan trade at levels differentfrom the fairvalueprice.So,certainlyonecan thenexpectthat there will be plenty ofmarket mistakes that an

interested speculator canexploit. But wait a minute!Havewe forgotten thecatch-22 of investing? How doesthe No Free Lunch principleaffect this situation? If aspeculator is to correct amarketmistake,hemust firsthavesomewayofidentifyingitasithappens.Istheresomestatisticalmethodthatenablesus to recognize the mistakespredicted by the theory of

behavioral economics whentheyoccur?

If we take the No FreeLunch principle seriously(andIdo),thenweareforcedto a sad conclusion. Despitethe insights generated bybehavioral finance into thebehaviorofrealinvestors,theeffects on market prices ofthesedeparturesfromrationalbehavior cannot bepredictable. They cannot

exhibit any statisticalregularity that can beexploitedbyaspeculator.Butwe can’t be satisfied withdeducing this using purereasonalone.Let’slookattheevidence.

In his paper “MarketEfficiency, Long RunReturns, and BehavioralFinance” (Journal ofFinancial Economics 49(1998), 283-306) Eugene

Fama investigates the claimsthat behavioral finance hasfound evidence thatundermines the efficientmarkets hypothesis. Heobserves that the classicalefficient markets hypothesisis rarely, if ever, comparedstatisticallywithanexplicitlyformulated alternative. Inother words, the behavioraleconomistswhopointoutthatthe efficient markets

hypothesisfailstostatisticallyexplain certain marketphenomena rarely offer anyspecific statistical model asan alternative. Thepredictions of behavioralfinance are rarely made in aform that can besystematicallycomparedwithmarket data. Fama tries tomakesuchcomparisonsinhispaper. He finds that theempiricalliteratureonmarket

mistakes does not reach anyunified conclusions as to thenature and direction of thesemistakes. In other words,there is no behavioral theorythatpredictstheexactkindofmistakeamarketwillmakeinaparticularcontext.

Fama concludes thatwhiletheclassicalefficientmarketstheoryhas itsweak spots, noone has come up with anytheory, behavioral or not,

which is more successful inexplaining the behavior offinancial markets. In otherwords, he confirms the NoFreeLunchprinciple.

NOFREELUNCHREDUX

Wheredoesthisleaveus?Wehave seen that there can be

littledoubtthatmarketsmakemistakes. They fluctuate farmore than does anyreasonable notion of fairvalue. Markets underreactandoverreact tonewsand toeconomic developments. Butthe No Free Lunch principleguaranteesthatthesemistakeswill be very hard to exploitsystematicallyusingavailablestatistical techniques. Therecan be no theory of market

mistakes that both confrontsthedatasuccessfullyandcanbe exploited by a typicalspeculator to earn above-averagereturns.

Discouraging as this stateof affairs may be to aprospective speculator, Ithink that one can progressonly by confronting itsquarely and thinking aboutits implications.TheNoFreeLunch principle is telling us

that success in speculationmust rest on personal traits,on abilities outside the reachofthemajorityofinvestors.Itmust also rest upon somearcane understanding ofmarket behavior and of thebehavior of investors andother speculators. Lewis andShort define the Latinadjective arcanus to mean athing that is hidden,concealed, secret, or private.

Tobeatthemarket,onemustdevelopandexploitakindofskill that is inaccessible tomost people.Todiscover thenature of this skill, we mustturn our gaze inward. Wemust focus on human natureand the social relations thatare thewarpandwoofof theworld inwhichwe live. It ishere in the speculator’srelationship to crowds, in hisability to identify them, and

in his ability to stand apartandactdifferentlyfromthemthathisedgemaybefound.

CHAPTER3

TheEdge

A theory of marketmistakes • investmentcrowds • a theorymost people cannotexploit•thesourceof

aspeculator’sprofit •togetalong,goalong• Keynes thespeculator • dangersof succeedingunconventionally•thevalueofsocialgroups•goalongandcreatea mistake • socialgroupsintheworldofinvestments •investment themes •peakoil • lifecycleof

aninvestmentcrowd•the boom and bust of1996-2002•thesocialcalculus of crowds •the vision of acontrarian trader • acontrarian trader’sedge

ATHEORYOFMARKET

MISTAKES

In this chapter and the nextwe are going to develop atheory of market mistakes.Our theory will identifysocial interactions amonginvestors as the probablecause of price movementsaway from the fair valueprice. We will see that thecooperative organization of

industrial society encouragestheformationofsocialgroupswhosefocusisonthisorthatfinancialmarket.Ithinkthesegroups can be aptly namedinvestmentcrowds.Thewordcrowd is intended to conveythe idea that the group’smembers show an unusualunity of purpose, thought,explanation, and expectation.A crowd is not simply acollectionofindividuals,each

of whom makes choicesindependently of the otherpeople in the crowd. Instead,crowd members imitate eachother. Indeed a crowd is akind of social black holebecauseitrelentlesslyattractspeople into its orbit ofthoughtandaction.

We focus our attention inthis chapter on the generalfact that investment crowdsare like other social groups

because they make it easierfor their members to surviveand prosper in society. Thehuman species stands outamongearth’screaturesinitsinstinctivedriveandabilitytoform and cooperate in largesocial groups. Indeed, itcannotbefarfromthetruthtoassert that this cooperativeinstinct is responsible for therapid development of humansociety over its relatively

short recorded history. Ourmotto could be that socialgroups make life easier andsafer.Everyoneknowsthistobe true.Consequently peopleare willing to join socialgroups and are even willingto suffer inconvenience orother costs to be members.Among these costs are acertain sacrifice ofindependence in thought andaction. Every member of a

social group cedes to thegroup some part of hisautonomy.

This perspective hasparticular implications forinvestment crowds. Eventhough individual investorsmay have the resources andskills required for rationalcalculation, such calculationsplayonlyaminor role in thelife of the crowd. Moreover,people may willingly join

investmentcrowdsevenwhenan inevitable consequence isbelow-average investmentperformance arising becauseon average the crowd’smembers buy above fairvalue and sell below it. Therewards of membership ininvestment crowds areusuallynotfinancialones.

If our theory is to be ofvalue, it must offer usguidance as speculators and

investors. It must identifyobservable phenomena thatare associated with marketmistakes at the time theyoccur, not just in hindsight.These phenomena will bediscussed in detail insubsequent chapters. For themoment I am content toemphasize the followingpoint: It is the ability toidentifyan investmentcrowd,to determine the crowd’s

position in its life cycle, andthentoactrationallyonthesedeductions that constitutes aspeculator’s edge. Aspeculator is successful onlytotheextentthatheiswillingto be antisocial in theinvestmentcontext.

Straightawaywerunintoaproblem.TheNoFreeLunchprinciple asserts that therecan be no theory of marketmistakes that can be

exploited by the typicalspeculator to earn above-average returns. How can Ireconcile this withmy intentto develop a comprehensibletheory of market mistakesbased on the action ofinvestment crowds? Won’tany such theory enable theaverageinvestoronthestreettobeatthemarket?

The resolution of thisconundrum will be found in

the observation that ourtheorycannotbeexploitedbythe typical speculator. Morethan40yearsofobservationsofmarketsandinvestorshaveconvinced me that mostpeople cannot exploit theimplications of any crowd-based theory of marketmistakes. The reason issimple: To do so wouldrequirethemtosevermanyofthe social bonds that connect

them to the investmentcommunity. It would requirethem to become antisocial inthe investmentworld, settingthemselves apart frominvestment crowds instead ofbeing a part of them. Ibelieve that the social bondsassociated with investmentcrowds are valued byinvestors not primarily forfinancial reasons but ratherfor the satisfaction found in

making connections withpeople with commoninterests. In fact, I believethat itwouldbe irrational formost people to sacrifice thesatisfaction arising fromcrowd participation on thealtar of financial gain. Thus,from an economic point ofview,itmakessensetoregardthisfinancialcosttoatypicalindividual (the opportunitycost of below-average

investment results) ofparticipating in investmentcrowds as the source of aspeculator’sprofit.

TOGETALONG,GOALONG

Worldlywisdomteaches that itis better for

reputation tofailconventionallythan tosucceedunconventionally.

—JohnMaynardKeynes,TheGeneralTheoryofEmployment,

Interest,andMoney

This observation by John

Maynard Keynes appearsamidst a brilliant analysis of

investor expectations andtheir role in speculativeactivity in the stock market.Few people know thatKeynes himself was a verysuccessfulspeculatorwhenhewasn’tcontributingtodebateson macroeconomic policy.For a brief description ofKeynes’ roller-coasterexperiences in themarkets, Irecommend that you readChapter 21 ofHedgehogging

byBartonBiggs(JohnWiley&Sons,2006).

Why might failingconventionally be better forone’s reputation thansucceedingunconventionally?We need not go far todiscover the reason. It is atrue (and therefore trite)observation that humanbeings are social animals.Success achieved by actingcontrary to social

conventions, contrary tobeliefs and values shared byone’s fellows, necessarilydiminishes a person’sstanding within hiscommunitiesandinthelargersociety. Antisocial behaviorisrarelyifeverrewarded.

Social groups naturallyform among individualswithcommon interests. Theymaybe biologically related, sharevocations, live near one

another, have similarpersonalities, and so on. Butthere is another side to thiscoin.Anyonewhosebehaviorisseentobeoutsidethenormforhisgroup,whodevelopsareputationforbeingdifferent,runstheriskofbeingcastouttothegroup’sfringes.Havingto live on the fringes of thegroup (or entirely outside it)canmakeperformingtheday-to-day tasks required for

survival difficult or evenimpossible. The group canexistandprotect itsmembersonly if they cooperate withone another. Thusmembership in social groupsentails obligations as well asbenefits. Among theseobligations are acceptance ofgroup beliefs and thewillingness to act inconformity with groupexpectations. Put another

way, group membership isopen only to those who aregoodcooperators.

Eccentricsarebydefinitionpeople who are not goodcooperators. As Keynesobserved, doing anythingunconventionally isdangerous for one’sreputation and is potentiallyharmful to one’s goodstanding in a social group.For this reason our social

antennae are finely tuned topick up signals from ourfriendsandassociatesthatweare somehow not meetinggroup expectations for ourbehaviorandopinions.Whenwe pick up these warningsignals we instantly feeluncomfortable,andwithgoodreason. Survival andprosperity depend on beingacceptedasamemberingoodstanding in all of our social

groups.

People who are good atgoing along with othermembers of their socialgroups get along well in lifeandintheworldsofworkandbusiness. They are wellconnected and are generallythe first to gain valuableinformation about newopportunities available togroup members. There isgood reason for this. Social

relationships are highwaysfor new ideas and for life-sustaining information aboutour environment. In eachsocial group there areexplorers and innovators,people who are the first tonotice a new opportunity toimprove their lives in theeconomic, social, or politicalsphere.Thenewsaboutthesenew opportunities movesalongthehighwayformedby

their relationships with othermembers of their socialgroups. In this way allmembers of a group canbenefit from the informationthatisgatheredbyonlyafew.The information highwaysformedbysocialbondsmakeitpossiblefortheentiregroupto adapt quickly and respondsuccessfully to new andpossibly life-threateningcircumstances.

We see then that thedevelopment of strong socialbonds confers a number ofevolutionary advantages.Acting conventionally andconforming to group normsandexpectationsforbehaviorand belief strengthen anindividual’s bonds with thegroup. It is no surprise, then,that Homo sapiens and hisancestors have survived onthisearthformillionsofyears

precisely because individualsare born with the instinctualneeds and skills for formingandstrengtheningthesesocialbonds. People value socialbonds for their own sakebecause they understand, ifonlyatanintuitivelevel,thatstrong social bonds canassuretheirsurvivalandtheirprosperity.

GOALONGANDCREATEAMISTAKE

The world of finance andinvestments is a microcosmof society itself. Within theworld of finance there aremany overlapping socialgroups.Weareinterestedinaparticularsortofsocialgroup,

the investment crowd. Oneidentifying mark of aninvestment crowd is that itconsistsof individualswhoseattentionisfocusedaroundaninvestmenttheme.

An investment theme is asystemofbeliefassertingthatsome asset is likely to yieldinvestment returns that arewell above (or below)average. Investment themesare generally associated with

a specific class of assets(stocks, bonds, commodities,real estate, etc.); with thestock of a specific company(e.g.,Google);withthestocksinaspecificindustrygrouporrelated groups (technology,dot-coms,telecommunications, energy,etc.); or with specificcommodities (e.g., oil, gold,silver, soybeans, wheat,corn).

I have emphasized theword system because theinvestment themeofacrowdmust always have anunderlying economic logicthat is easy to state andappeals toordinarypeople. Itis even better if the internallogicoftheinvestmentthemesquareswithfactspeoplecanpersonally experience. Thissystem of belief must leadnaturally to the conclusion

that themarket onwhich thecrowd is focused will yieldsuperior investment returns.This weightiness of thecrowd’sthemeisessentialforit tobepersuasive. It iswhatmakes the crowd capable ofattracting new members andpermits the crowd to growlarge enough to cause amarket tomake a substantialmistake.

Not allmarket-investment-

themedsocialgroupsthatcanbe found in the world offinance become investmentcrowds.For this tohappen,atrigger or precipitating eventis needed. Generally thisprecipitatingeventisabigorsustained change in themarket price of the asset onwhich the group is focused.This change has to be in thedirection the group’s themehas predicted. When the

market price changes in adramatic and predictedfashion, the group begins toattract the attention ofinvestors and the generalpublic who had not beenaware of this investmenttheme. The price change haspresumably made earlyadherents to the investmenttheme wealthy. This addsenormous credibility to thelogic of the investment

theme.

It is at this point that aninvestment-themed socialgroup begins itstransformation into aninvestment crowd. To theoutside world the groupappearssmartandsuccessful,andlotsofpeoplewant tobepartofarisingandprominentsocial group. The naturalsocial process of imitationkicks in, and the pressure to

conform to a visiblysuccessful investmentstrategy rises. These forcesjoin to create an investmentcrowd whose membersexhibitaunityofthoughtandaction not typical of a large,randomly chosen group ofindividualswhoparticipateinagivenmarket.

A good example of thisphenomenon is the peak oilinvestment crowd. Peak oil

believers assert thatworldwide production ofcrude oil will reach its peaksometime during the firstdecadeor twoof the twenty-first century.The implicationis that crude oil prices havenowhere to go but upward.One important reasona largesocial group has grownaround the peak oil theme isthat ordinary peopleexperience its implications

every time they fill up theirautomobiles’ gas tanks. Thisreinforcing personalexperience is a veryimportant factor that helpstransform an investment-themed social group into aninvestment crowd. Thetheme’s logic has to besomething that can beconcretely experienced byordinary individuals, not justbyinvestmentprofessionals.

Crude oil traded as low as$11 per barrel in 1998 afterfalling from a high price of$40 in 1990. The peak oiltheme had only a smallnumberofadherentsin1998,although its logic was asstrong then as it is now, 10years later. But it was onlyafter thepricehadmovedupmore than 400 percent to anew high above $40 in 2004thatthepeakoilthemebegan

to attract significant numbersof adherents and aninvestment crowd began toformaround this theme.Thisinvestment crowd is stillgrowingasIwritethisinJuly2008withoilaroundthe$130level.

Notice that the peak oilsocial group began itstransformation into aninvestment crowd only afterthe price of crude oil had

movedup400percentoveraperiodofsixyears.Thisisthesingle most useful clue thataninvestmentcrowdisintheprocess of forming. Eventhough the underlyingeconomic logic of peak oilmade asmuch sense in 1998as it did in 2004, it took adramatic price advance incrude oil to new historicalhighstoconvincepeoplethatthe logic was correct and

potentially profitable. Thepricechange itselfwas takenas confirming evidence forthevalidityofthetheme.

This is a nearly universalcharacteristic of investmentcrowds. Any social group’sgrowth is fed by the successof its foundingmembers.Aninvestmentcrowd’sgrowthisstimulated by the financialsuccessofitsearlyadherents.Theyhavegottenrichfroma

dramaticupwardmoveintheprice of some asset. Thefinancial success of earlyinnovators provides the fuelto drive the new investmenttheme along the highways ofsocial connections and thusincrease the numbers ofconvertstothetheme’slogic.An investment crowd formsas the group attractsadherents who have noparticular expertise or

experience with the theme’sasset.

Itisatthisjuncturethattheformation of an investmentcrowd causes the market tobegin its departure from fairvalue. New members of thecrowd accept the investmentthemeasproventobecorrectbecause of the big change inmarket price they haveobserved. They no longerattempt independent

assessments of therelationship of price to fairvalue and instead accept theonwardandupwardassertionof fellow crowd members atface value. This willingsuspension of independentthoughtbycrowdmembersistheexplanationforthemarketmistake associated with thecrowd. As the crowd’s sizegrows, its collective marketposition forces the market

price much higher than anyreasonable estimate of fairvalue. The resulting bubblemay well keep the marketpricetoohighforasustainedperiod of time if the group’ssocial bonds are strong andcontinually reinforced. Buteventually all such bubblesmustdeflateastheunderlyingforces of economiccompetitionassertthemselvesand drive the profitability of

the associated businessesdowntonormallevels.

This pattern of the lifecycleofaninvestmentcrowdcan be seen in several otherinvestment crowds thatformed in the stock marketduring the boom and bust of1996-2002. During theseyears several investmentcrowds formed around thethemes of Internet retailing,telecom growth, and

computerequipment/software.Beliefinthe transformative power ofthe Internet, the computer,and telecommunications wasstrong,andthestocksofnewcompanies associated withthese themes soared evenwhen no evidence of profitsexisted.Thewildfluctuationsassociated with the resultingstockmarketboomgavebirthto a day-trading crowd. Its

members bought and soldstocksseveraltimeseachdayhoping to outguess theirfellows about the effects ofthe latest news on theirfavorite stocks and to profitfrom the wide intradayfluctuations that werecommonatthetime.

Thatthesecrowdsforcethestockmarketintoamistakeofgeneral overvaluation is nolonger disputed, although at

the timemost people refusedto acknowledge thispossibility.Onceacrowdhasattracted all the adherents itcan, an inevitable process ofdisintegrationbegins.Whenalarge investment crowddisintegrates, the market thatis its focus typically movesfrom overvaluation toundervaluation with no stopin between. Remember therollercoaster!

This process is wellillustratedbythesequeltothe1996-2000 boom.During the2000-2002 bear market instock prices, the NASDAQComposite index (home tothe Internet, computer, andtelecom stocks) fell from the5,000levelto1,100,adropofalmost80percent.Thestocksof the old bricks-and-mortareconomy did not escape thiswashout. Their home, the

S&P 500 index, fell 50percent during the same bearmarket.

The demise of theseinvestment crowds was sotraumatic that in reactionanother investment crowdformed in 2002. Its themewas that everyone associatedwithWallStreetwasacrookand that stock prices had togo even lower than they hadalready fallen. The 2000-

2002 bear market experiencemade this logic seem veryplausible, and as a resultmany otherwise saneinvestors dramaticallyreduced the common stockportions of their portfolios.Thebeliefsofthiscrowdkeptstock prices too low relativeto fair value during thesecondhalfof2002.But thiscrowd, too, began itsinevitable disintegration in

2003. Over the next fiveyears the market averagesdoubled.

THESOCIALCALCULUSOF

CROWDS

Why must the social groupsassociated with investment

themes so often turn intoinvestment crowds and forceprices well above or belowfair value? Why mustinvestment crowds be acommon feature of thefinancial landscape? I haveargued that people want andneed to belong to socialgroups. The incentive to joinsuccessful groups is strong.After all, such groups playimportant roles in alerting

their members to newopportunities for social andeconomic advancement. Andusuallyonecanmakealotofmoney (at least for a while)by investing with theinvestment themeofagroup.But more than this,membership in a successfulgroupcanbeitsownreward.People often find satisfactionandgainprestigeamongtheirfriends and family through

their membership in sociallyand financially prominentgroups.One need only recallthe kudos collected by dot-com investors andentrepreneurs, venturecapitalists, and even daytraders during the 1999-2000stock market bubble in theUnitedStates.

Theseconsiderationsimplythatpeople shouldbewillingto pay a price for their

membership inan investmentcrowd.Aslongasthispriceisseen to be less than thebenefit associatedwithgroupmembership, the crowd willgrow. What are the costs ofgroupmembership?Andhowdo these balance against thefinancial and nonfinancialrewards of groupmembership?

Forinvestmentcrowds,theprimary cost of group

membership manifests itselfonly near the end of acrowd’s life cycle. Once thecrowd’s investment themehas driven market prices toohighortoolow,theinevitablereturnoftheassetpricetofairvaluecauses thecrowd’s latejoiners to incur substantialinvestment losses.And ithasbeenmy observation that themajority of members of anyinvestment crowd join only

aftertheassetispricedabovefair value (for a bullishinvestment theme) or belowfairvalue(forabearishone).It is important to rememberthatthissortofcostisuniqueto investment crowds and isnot generally associatedwithmembershipinanyothertypeof social group. For thisreason it is not likely to beanticipated by people whohave little experience as

members of investmentcrowds.

Againstthesecostsmustbelaid the benefits of crowdmembership. As I have said,social approval and prestigearetheprincipalbenefits.Butone must keep in mind thatinvestment crowds developpreciselybecause thegroup’searly joiners and innovatorsachieved very much above-average investment returns.

These above-average returnsactasakindofsocialbeaconlighting the night ofinvestmentuncertainty.Everycrowdmemberisattractedbythis beacon and motivatedsuperficially by the prospectof duplicating this above-average investmentperformance.

Of course such optimisticexpectations will result indisappointment for the

majority of the investmentcrowd, those who adopt theinvestment theme late in thecrowd’s life cycle. For thisreason the pursuit of aninvestment theme is oftensaid to reflect ill-informedoreven economically irrationalchoices bymany individuals.Many economists wouldadopt this view but I do notacceptit.

First of all, I think the

typical investor is likely tojoin only a single investmentcrowd in his investmentlifetime. The drop in assetvalue as the crowddisintegrates is traumatic andleads the investor to a vownever to repeat the mistakeagain.Thusmostmembersofany substantial investmentcrowd are novices—notrepeated joiners of multiplecrowds—and so have no

statisticalbasisuponwhichtopredict the outcome of theircrowd membership.Secondly, as I haveemphasized there arenonfinancial considerationsthatenter intothecalculusofchoice for people in thiscontext.Joiningsocialgroupsand maintaining membershiptiesaregenerallygoodthingsin themselves. A person’snetwork of social groups is

thewarpandwoofofhis lifein society. Consequently, thelife strategy of joiningsuccessful and prestigioussocial groups is one that weall naturally adopt. That thismay often prove to be acostly error when joininginvestment crowds does notmuch diminish its value as agenerally successful survivalstrategyinsociety.

We see then that people

haveastrongincentivetojoininvestmentcrowds,notjustinthe hope of achievingsuperior investment returnsbut also because joiningprominent and prestigioussocial groups is a goodsurvival strategy in all socialrealms. Investment crowdsdifferfrommanyothersocialgroups in that they generallyhave limited life spans.Moreover, the majority of

members in such groups arelikely to suffer significantlybelow-average investmentresults.Yetthecostofbelow-average investmentperformance—if it can berecognized and calculated atall—can be seen as largelyoffset by the prestige andsatisfaction associated withjoining prominent and(temporarily) successfulsocial groups. And it is the

opportunity cost of thisbelow-average investmentperformancethatisthesourceofaspeculator’sprofit.

THEVISIONOFACONTRARIAN

TRADER

Why is it important to

understand investmentcrowds? I have argued thatlarge investment crowds areassociated with significantmarketmistakes,situationsinwhich the price of a stock,bond,orcommodityisforcedtoohighortoolowrelativetoits fair value. If this is true,then a speculator canpotentially earn above-average returns by exploitingthis connection. One need

onlywatchfortheemergenceof an investment crowd. Asthe crowd grows, it makessense to invest in harmonywith the crowd’s investmenttheme. But eventually thecrowd grows so large that itforces the market price wellpast fair value. At this pointthe investor needs to eitherstep aside from the crowd’stheme investment or eveninvestinanoppositetheme.

This is the strategic visionofthecontrariantrader.Iusethe word trader here insteadofthewordinvestorbecauseIbelieve that market mistakesaregenerallytemporaryones.A contrarian trader does notintend to hold an investmentover several bull and bearcycles. Instead he is focusedon taking advantage of amarket price that is above orbelowfairvalueandwilllater

abandon his position whenthe market returns to its fairvalueprice.There is no suchthing as a long-runinvestment for a contrariantrader. His business isexploiting market mistakesarisingfromthegrowthofaninvestment crowd but thenstepping aside from hisinvestmentasthelifecycleofthe crowd inevitably returnspricetofairvalue.

To implement thiscontrarian trading strategy,one must become skilled indiscovering emerging and/orpopular investment themesandinevaluatingthestrengthand stage of development ofthe associated crowd. Onemust learn to understand therole the news media play inreinforcing and popularizinginvestment themes. Inaddition, one must develop

theskillsneededtoplacethisinformation in its propermarket context. In otherwords, one must learn tocompare the marketperformance of theinvestment theme’s asset tohistorical norms and to theperformance of othermarkets.Subsequentchaptersexplain how you may begintodeveloptheseskills.

Why does the contrarian

trader have an edge on theaverage investor? How is itpossible for him to earnabove-average returns? Whydoesn’t the No Free Lunchprincipleapplyequallytothecontrarian strategy discussedin this book? What is thesource of the contrariantrader’sorinvestor’sedge?

The simple fact is that acontrarian trader must bydefinitionbeanonconformist

to be successful. This is thekey to understanding thedifficulties and theopportunities associated witha contrarian stance towardmarkets.

I have argued that everypersonisbornwithaninstinctto join social groups andcultivate social bonds withother individuals. Suchinstincts and social skillsendow individuals with an

evolutionary advantage. Forthis reason one expects andobserves that people are farmore comfortable acceptingthe conventional wisdom oftheirsocialgroupsandactingin accord with suchconventions. This is true ofinvestment crowds no lessthan of groups that form thelargersocietyinwhichwealllive. Yet a contrarian tradermust place himself apart

from investment crowds. Bychoice he becomes a kind ofsocialoutcast in theworldofinvestments, the very worldto which he has chosen todevotesomuchtime,energy,and money. Few people cancomfortably live with thissortof emotionaldissonance.And this internal conflict isalways felt most acutelywhen the financial stakes arehighest,when the groupthink

phenomenon associated withinvestment crowds is mostintense.

This is why there are sofewcontrarianinvestors,evenamong professional moneymanagers.Everyprofessionalmoneymanagerknowsthatitis better “to failconventionally than tosucceed unconventionally.”Why? Because everyinvestment strategy fails on

occasion, but if hisinvestment strategy isunconventional as well, itsfailure will get the managerfired. Nonconformists arealwaysonaveryshortleash.

Itishisabilitytosuffertheinternal conflicts and thesocial isolation associatedwith a contrarian investmentstance that is the source of acontrarian trader’s edge. Ineconomic terminology this is

a very high barrier to entryinto the speculator’sprofession.Onemustbeableto thinkclearlyand toactonone’s contrarian conclusionsin the face of a market thatfor the moment seemsdetermined to reduce thevalueofone’sportfolio.Veryfew people can do this. ForthisreasontheNoFreeLunchprinciple does not precludeabove-averagemarket returns

for the contrarian trader.There are so few contrariantradersthatthemarketreturnsgained by pursuing thisapproach will remain aboveaverage and will not becompeted away as long associety rests upon afoundation of strong socialbondsamongitsmembers.

CHAPTER4

TheWisdomandFolliesofCrowds

Another side tocollectivebehavior•acrowdcanbe smarterthan any of its

members • when canthis happen? • thedanger of self-fulfilling prophecy •the importance ofindependent judgment• Surowiecki’s bookon the wisdom ofcrowds•threecriteriafor collective wisdom•whataboutthestockmarket? • failure ofthe independent

decision-makingcriterion • whenmarkets have betterinformation thanindividuals • whybelief in a market’scollectivewisdomwillleadtocollectivefolly•Keynesonthenatureof speculation •forecasting marketpsychology •conventional belief

that tomorrowwill beprettymuchliketoday•market prices liableto changedramatically inresponse to factorsthat are of no long-run significance •descent fromcollectivewisdomintothe whirlpool ofspeculation •information cascades

• a theory of fads,fashion, custom, andcultural change •information cascadesand investmentcrowds • valueinvestors bring theinformation cascadetoahalt • fragility ofinformation cascadesand investmentcrowds

CANACROWDBEWISERTHANITS

MEMBERS?

In this chapter we take adifferent look at thephenomenon of crowds. InChapter 3 I argued thatinvestmentcrowdsarisefroman inherently social process.People instinctively want to

be part of prominent andsuccessful social groups.Moreover, an investmentcrowd implicitly promisesnew members above-averageinvestment returns similar tothose that were achieved bythecrowd’sinitialcoregroupof believers. This implicitpromise is backed up by theveryvisible,predictedchangein the price of the crowd’sfavorite asset, which has

made the crowd’s originalmembers look smart andsuccessful. At this point theforces of conformity andimitation that encouragepeople to join successful andprominent social groups kickin. The crowd grows to thepointatwhichitssizecreatesamarketmistake.

When described in thisway, members of aninvestmentcrowdmayappear

to be acting irrationally (i.e.,contrary to their ownperceived interests).And thismaybetrue.Thepressurestoconform to group behaviorand to accept the social andpromised financial benefitsattached to participation in asuccessful group may welloverwhelm individuals’capacity for rationalcalculation. The consequentmarket mistake may then be

takenforevidenceofthefollyof the investment crowd’sbehavior.

Butthereisanothersidetothe collective behavior ofsocial groups. Crowds maysometimes exhibit a kind ofcollective wisdom instead ofthe collective folly I haveascribed to investmentcrowds. It is a generalprinciple of scientific inquirythat to understand a

phenomenon, in our case theactivities of investmentcrowds,itoftenhelpstostudythepolaroppositeofthesamephenomenon. The polaropposite of an investmentcrowdisacrowdthatexhibitsa kind of collective wisdom.A collectively wise crowdoperating in thestockmarketwould cause prices to hoverconsistently near fair value.This of course is the

prediction of standardeconomic theory.Economistsgenerally see markets ascrowds of independentindividuals that exhibit thecollective wisdom found inthemarket equilibriumprice.Thispriceiscollectivelywisein that it accurately reflectsall that is known about thecurrent and prospectiveeconomicsituation.

Sowhenmightweexpecta

large group of individuals, acrowdinthecolloquialsense,toexhibitcollectivewisdom?When might the same groupshow collective folly? Byansweringthesequestionswecan gain insight into thenature of investment crowdsand discover why they areassociated with marketmistakes.

THENEEDFORCOLLECTIVEWISDOM

Let’s begin by looking moreclosely at the nature of thecollective wisdom thatdeterminesprices in financialmarkets. If this arises frominformation about underlyingeconomic conditions that

investors investigateindependently from oneanother, I think we wouldexpect the resulting marketpricetobeagoodassessmentof fairvalue. In this case themarketislikelytoactwisely.But if instead investors’wisdom consists essentiallyof their perceptions of otherinvestors’ information,beliefs, andactions, we havea problem. In this case the

door is opened to self-fulfilling prophecy—herdbehavior.

First consider the situationinwhich individual investorsact on private informationabout economic conditions.Presumably this informationcomesfromacombinationofpersonal experience andresearch. Of course peoplemay make mistakes whenthey assess current

conditions, when they try tojudge future conditions, andwhen they try to translatethese judgments into anappropriate investmentpolicy.But if investorsmakethese judgments andinvestment decisionsindependently from oneanother, their mistakes areverylikelytocancelout.Theaverage investment choicethenislikelytoreflectamore

accurate assessmentof futureconditions than does anyindividual’schoice.

In this situation, investors’collective judgment is betterthan the judgment of anysingle individual. The factthat people are diverse intheir thinking processes, inthe information they have,and in their ability to choosegood investments ensures adiversity in the type of

mistakestheywillmake.Andthis diversity in mistakesmeans that, collectively, theydon’t make any mistake atall!

This is an amazingphenomenon and one verydifficult to accept. But youdon’t have to take my wordforit.AfewyearsagoJamesSurowiecki wrote a bookentitled The Wisdom ofCrowds (Random House,

2004). He examinedsituations inwhichgroupsofpeople had to makeindividual choices orpredictions. The prototype isthe game of guessing howmany marbles are in a largeglass jar. No individual islikelytomakeaveryaccurateguess. But time and timeagain the average guess ofthe number of marbles turnsouttobeamazinglyaccurate.

The group’s collectiveknowledge is superior to thatofanyofitsmembers!

Surowiecki recounts manyexamplesofthisphenomenonin his book and does so in avery entertaining andilluminatingway.Buthedoesmore than just entertain. Heidentifiesthreecharacteristicsofsituationsinwhichwecanexpect a group of people tomake a collectively wise

choice. First, the knowledgebase of the group must bediverse, and the morediversity in knowledge andexperienceamongthegroup’smembers the better. Second,individualsinthegroupmustmake their choices withoutregard for the choices madeby other group members.Finally, there should be adefinitepointintimeatwhichthe reward for choosingwell

is distributed among groupmembers.Thisrewardshouldbe connected with someobjectively observableexternal event and havenothing to do with theinternal workings of thegroupdecisionprocess.Whenthese conditions are met,eitherbychanceorbydesign,Surowiecki asserts that thecollective wisdom of thegroup will yield an average

choiceordecisionsuperiortoany that an individual groupmemberislikelytomake.

In Surowiecki’s work wefindthekeytounderstandingwhy economic theory canmake successful predictionseven though each individualconsumer, investor, orbusinessperson may havebiasesandmakemistakes. Insituations where people actindependently from one

another, deviations fromrational behavior (themistakes and biases ofindividuals) will tend tocancel out. In these sorts ofmarket situations, eachmarket participant knows hisowninterestsandcollectshisown information aboutunderlying economicconditions. As a group,market participants actcompetitively and therefore

independently, makingchoiceswithout regard to thechoicesmade by others. Therewardsforchoosingwellareentirely appropriated by eachindividual and accrue at adefinite point (or points) intime. In such circumstancesone can reasonably expect tosee mistakes made byindividualsoffsetoneanotherso that the group as awholemakes nomistake at all.The

collective wisdom of themarketplace produces a pricethat accurately reflects fairvalue. Sowe should think ofclassical economics as thestudy of collective action insituations inwhich collectivewisdomcanmanifestitself.

INDEPENDENTDECISIONSINTHE

FINANCIALMARKETS

Let’s continue alongSurowiecki’spathtoseeifwecan expect the stock marketto bewise.Canwe expect itto exhibit the wisdom ofcrowds? Remember thatcrowds are likely to showcollectivewisdomwhen theirmembers have diverse

information, make decisionsindependently from oneanother, and expectforeseeable payoffs for theirchoicesatsomedefinitepointintime.

Certainly stock marketinvestors as a group haveaccess to very diverseinformation. Indeed all theinformation relevant tocorporate earnings prospectsis available in the economy

somewhere to someone.Andfor the most part, stockmarket investors makedecisions independently fromone another without anyformal and very littleinformalmutualconsultation.Sothestockmarketseemstosatisfy two of Surowiecki’scriteria.

It is the third ofSurowiecki’s criteria whosefailure opens the door to the

riseofinvestmentcrowdsandcauses collective wisdom tomake only occasionalappearances in the stockmarket. The stock marketgameneverends.Indeed,thisimportant characteristicdistinguishes equityownershipfrombondholders’interest in a corporation.Dividend and interestpaymentsarepredictable.Butcapital gains are not, and

these are an importantcomponent of stock marketreturns. In fact, it is thepursuit of capital gains thatmotivates many if not allinvestors. And capital gainsarise only when one canexpect that at someforeseeabletimeinthefutureother investors will price anassetdifferentlyfromthewaythey are pricing it now. Thispursuitofcapitalgains is the

reason thatmarkets for long-lived or perpetual assets areparticularly vulnerable to thefolliesof collectivebehavior.No capital gains, noinvestment crowd!Topursuecapital gains and avoidcapital losses, investorsmustanticipate the beliefs andactionsofotherinvestors.Butif this happens, individualswill no longer makeinvestment choices

independently, causing thecatastrophic failure ofSurowiecki’s secondcriterion,too.

There is another way ofseeing why Surowiecki’sindependent action criterionwill fail in the stock marketandthusmaketheemergenceof collective folly likely.Suppose for the sake ofargument that stock marketsgenerally price corporate

assetsatfairvalueandthatinthis way the market reflectsthe collective wisdom ofinvestors. This situation isnecessarilyveryunstable.Forifthestockmarket’sestimateoffairvalueisbetterthantheestimate by any singleindividual, it follows that aninvestor should trust themarket’s estimate more thanhisown.Afterall,themarkethas better information than

he does! But if the investorprefers the market’sinformationover his own, heis thenacting inconcertwithother investors, notindependently from them.Even worse, why should anindividual investor evenbother to take the trouble toconstruct an independentassessment of fair value?After all, he won’t be usingit!

Think about what thismeans. If the stock marketexhibits the wisdom ofcrowds, then individualinvestors will correctly seethatthemarketpricecontainsmore information than theyhave individually. So eachinvestor will no longer havereason to collect and analyzeinformation for his own use.Buthow thencan themarketprice reflect information that

noonebotherstocollect?Itisas if people were asked toguess the number ofmarblesin a jar without ever seeingthe jar itself! Onewould notexpect collective wisdom toemergeinsuchasituation.

We see then that ifinvestors actually believe thestock market trades near fairvalue, we can conclude thatthe stock market willprobably not trade near fair

value. If all investors decidetorelyonthemarketpriceforinformation about underlyingeconomic conditions, thestock market will no longerbe moored to thoseconditions.

Economists have found away of resolving this stockmarketcatch-22.Theycallitthe theory of rationalexpectations, and theadvocates of this theory hold

that we are likely to see theeconomy settle into what iscalledarationalexpectationsequilibrium,althoughIpreferthe term collective wisdomequilibrium.This isawayofresolving the paradoxicalnature of collective wisdomin a market situation. Whenthe stock market is in acollective wisdomequilibrium investors usetheir private information but

supplement it withinformation they glean fromthe market price itself.Everythingworksouthappilyintheend.Butdoesit?

Economists know that acollective wisdomequilibriumcanbequirkyandfragile. The market pricemight even wind up beinginfluencedbyfactors(likethephases of themoon) that areirrelevant to the corporate

profits. This fragility arisesprecisely because everyoneknowsthatthemarketpriceisthe best single summary ofwhat everyone else knowsabout future prospects. Forthis reason external eventscancausethemarketpricetobecome unmoored fromeconomic reality. People canbegintobelieveunreasonablethings simply because themarket price tells them to, a

distressingechoof“Thedevilmade me do it.” After all,isn’t the market wiser thanany individual? If enoughpeople believe in thecollectivewisdomofmarkets,then we perforce enter theworldofcollectivefolly.

The fragility that attends acollective wisdomequilibrium is evident in thefrequency with whichinvestment crowds form and

disrupt the asset pricingprocess associated with suchan equilibrium. But eventhough I have chosen todescribe this outcome ascollective folly, I do notbelieve that it necessarilyarisesfromindividualfolly.Ibelieve that members of aninvestment crowd may havegoodreasonsforadoptingthecrowd’s beliefs as their own.It may be perfectly rational

for an individual to heed thecrowd. To see why this canhappen, we return to thewritingsofperhapsthesinglemost influential economistofthetwentiethcentury.

FORECASTINGMARKET

PSYCHOLOGY

John Maynard Keynes,himself an experienced andsuccessful speculator, hasdefined speculation as theactivity of forecasting thepsychology of the market.(The quotations in thissection can be found inChapter 12, sections 5 and 6of his 1936 treatise TheGeneral Theory ofEmployment, Interest, andMoney.) Keynes goes on to

elaborate on his definition ofspeculation.Heobserves thatthe energies and skill of theprofessional investor areoften occupied with“foreseeing changes in theconventional basis ofvaluation a short time aheadoftheinvestingpublic.”Suchan investor is concerned notaboutwhatastockisworthtothe man who “buys it forkeepsbutratherwithwhatthe

marketwillvalue it at,underthe influence of masspsychology,threemonthsorayearhence.”

Why might a professionalinvestorbemoreinterestedinforecasting short-runfluctuations instead of long-run changes in fair value? InKeynes’ view, this short-runfocusarisespreciselybecausemarketpricesareobservedtofluctuate far more than is

justifiedbythearrivalofnewinformationaboutlikelylong-run corporate and economicperformance. Consequently,investors are naturallyfocusedonpossibleshort-runcapital gains and losses.Andprofessionals’ livelihoodsdepend more on their short-run performance relative tothatofotherprofessionals.

But Keynes is well awarethat this elicits another

question: Why do pricesfluctuatesomuchintheshortrun? This fact Keynesexplains by observing thatmarkets normally operate onthe basis of a widely heldconvention—that “theexisting state of affairs willcontinue indefinitely.” It isthis convention, Keynesbelieves, that is thefoundation upon whichbeliefs about future market

returns are constructed. Buthe asserts that such aconvention is necessarilyfragile and likely to bedisrupted by any unexpectedeconomic drama played outon the national or worldstage: “A conventionalvaluationwhichisestablishedas the outcome of the masspsychologyofalargenumberof ignorant individuals isliable to change violently as

the result of a suddenfluctuation of opinion due tofactors which do not reallymakemuch difference to the[long-run]prospectiveyield.”

The word psychology isitselfofinteresthere.Itrefersto the collectivemental stateof investors. The implicationis that investorpsychology isin principle somethingdistinct and separate fromobjective economic facts.

Keynes makes this clearwhen he elaborates on hisviewsbysaying:

[T]he professionalinvestor is forced toconcern himself withthe anticipation ofimpendingchanges,inthe news or in theatmosphere, of thekindwhichexperienceshows that the masspsychology of the

market is mostinfluenced. Andagain: the actualprivate object of themost skilledinvestmentto-dayisto“beatthegun,”astheAmericans so wellexpress it, to outwitthecrowd,andtopassthe bad, ordepreciating, half-crown to the other

fellow.

Ina subsequentparagraph,Keynes adopts his famousbeauty contest metaphor forspeculation. In Keynes’description of the contest, aprize goes to the observer ofthe beauty contest whosechoice of the most beautifulcontestant most closelycorresponds to the averagechoicemade by all the otherobservers.Hesays:

Each competitor hasto pick, not thosefaceswhichhehimselffinds prettiest, butthose which he thinkslikeliest to catch thefancy of the othercompetitors, all ofwhom are looking atthe problem from thesamepoint of view. Itis not a case ofchoosing thosewhich,

to the best of one’sjudgment, are reallytheprettiest, noreventhose which averageopinion genuinelythinks the prettiest.We have reached thethirddegreewherewedevote ourintelligences toanticipating whataverage opinionexpects the average

opinion to be. Andthere are some, Ibelieve, who practicethe fourth, fifth andhigherdegrees.

Keynes also sees a naturaltension between enterpriseand speculation in everyfinancialmarket.Heobservesthat there are indeed largeprofitstobemadeinthelongrun by enterprisingindividuals who operate

unperturbed by thespeculative ebb and flow ofmarket psychology, who“invest on the best genuinelong-term expectations thatcan be framed.” Keynesfurthernotes:

[I]t makes a vastdifference to aninvestment marketwhether or not they[long-run, enterprise-type investors]

predominate in theirinfluence over thegame-players....Speculators may dono harm as bubblesona steady streamofenterprise. But theposition is seriouswhen enterprisebecomes a bubble onthe whirlpool ofspeculation.When thecapital development

of a country becomesa by-product of theactivities of a casinothe job is likely to beill-done.

This is the themeof all ofKeynes’ writing on thebehavior of investors. Hisexperience as a speculatortaught him that everymarket’s collective wisdomequilibrium is fragile. It isprone to disruption by the

forces of short-runspeculation arising fromchanges inmass psychology.It is perfectly rational forinvestors,professionalornot,to pay careful attention toshort-run changes inpsychology. Their livelihoodand net worth depend on it.But speculation aboutchanges in investmentpsychologycaneasilyleadtoa disruption of a collective

wisdom equilibrium—to asituation in which enterprisebecomes a bubble on awhirlpoolofspeculation.

INFORMATIONCASCADESINTOTHEWHIRLPOOLOFSPECULATION

Let’s now examine theprocessbywhichacollectivewisdom equilibrium in thestockmarketcandissolveinawhirlpool of speculation.Surprisingly,economistshavesome important things to sayabout these departures fromcollectivewisdom.

Supposewelookcloselyatthe behavior of investmentcrowds. They share oneimportant characteristic: The

membersofeveryinvestmentcrowd are certain that thecrowd’s size is evidence ofthecorrectnessofthecrowd’sbeliefs.Somanypeoplecan’tbe wrong! An investoroutside the crowd isimpressed not just by thecrowd’s investment successbut by the unanimity of itsbeliefs and expectations.Experience reinforced by aninstinctivebeliefincollective

wisdom then causes him toput aside his skepticism. Hebelieves the crowd’smembers must collectivelyknow more than he does. Inthiswaythecrowdgainsonemoremember.

But it is the nature of aninvestment crowd that itsshared beliefs are not simplythe average the independentbeliefs of the crowd’smembers. Remember that an

investment crowd growsbecause outsiders prefer toreplacetheirownbeliefswithwhat they thinkare themoreaccurate and wise beliefs ofthe crowd. In this way thecrowd’ssharedbeliefislikeacosmic black hole. It is apowerful conviction, usuallysupported by well-knownfacts, which is an irresistibleattraction for individuals andwhich overwhelms their

personal knowledge andexperience.

Surprisingly, this behaviorneed not be irrational on itsface. It has been studied byeconomists. Itgoesunder thename of an informationcascade .Theoriginalsourcefor this idea is a paper bySushil Bikhchandani, DavidHirshleifer, and Ivo Welch(BHI) that was published inthe Journal of Political

Economy in 1992 (pp. 992-1026) under the title “ATheory of Fads, Fashion,Custom,andCulturalChangeasInformationCascades.”

Simplyput,aninformationcascade is a situation inwhich an individual imitatesthebehaviorofotherswithoutregard to his owninformation. He does sobecause he believes that hisowninformationisinferiorto

the information of those hechooses to imitate. The ideaofsuccessiveimitation,thatacascade is a sequence ofchoices made over time bydifferent people, is importanthere.And it is the sequencedcascade of imitation that Ibelieve chronicles the life ofanyinvestmentcrowd.

Why should an individualchoose to imitate the actionsof others? Sociologists have

studied this phenomenoncarefully. Among theexplanations they offer arethepreferenceforconformity(which has high survivalvalue for an individual whowishes to maintain strongsocial bonds), as well as thefact that a strong group canenforcesanctionsondeviants.But as BHI point out, thesociological explanationsaren’t sufficient to explain

whymassbehaviorissooftenfragile is thesense thatsmallshocks can result in bigchanges.

Information cascades arefragile precisely because thecollective informationcontained in the cascade canbeseenasapyramidstandingupside down on its point orvertex. A very littleinformation held by a fewindividualsrightatthestartof

the cascade induces a greatnumber of individuals toabandon their owncollectively more substantialinformation and insteadimitate the early innovators.Any small piece ofinformationthatsubsequentlyis seen by some member ofthe cascade to contradict theinformation upon which thecascadeisbuiltcancausetheentirestructuretotipoverand

collapse.

Here in the theory ofinformation cascades weagainencounter the themeoffragility inmarket and groupbehavior. Changes incollective behavior andmasspsychologycanoccur rapidlyand for no obvious reason.Thebestway to thinkof thisphenomenon is tocompare itto the spreadofanepidemic.A wonderful discussion of

epidemic-related aspects ofcollective behavior can befound in the book TheTipping Point by MalcomGladwell (Little, Brown,2000). His book is subtitledHowLittleThingsCanMakeaBigDifference,andithasalot to say about the reasonspeople imitate each other,each illustrated byilluminatingexamples.

Let’sseehowthetheoryof

information cascades shedslight on the behavior ofinvestment crowds. In thetheory of cascades, a personimitates the actions of thosewhohaveprecededhiminthecascade because he believesthat they know something hedoes not know. Moreover,this belief in the superiorityofotherpeople’s informationcan be an objectively correctone, a belief founded on the

best statistical use of one’sowninformation.

An investorwho isnotyetpart of an investment crowdgenerallyknowsanumberofthings. He knows that thecrowd is focused on an assetwhosepricehaschangedalotinarelativelyshortperiodoftime. Indeed, this pricechangemaywellbewhathasattracted our hypotheticalinvestor’sattentioninthefirst

place. Our investor alsoknows the beliefs andforecasts shared by thecrowd, which he has learnedfromitscurrentmembers.Tobe persuasive, these must begrounded in facts that arepublic knowledge. There hasalready been a big pricechange in the asset, and thislends more credence to thecrowd’s beliefs. Yet anotherelementofpersuasionmaybe

the financial gains made byfriends and acquaintances ofour investor who are alreadymembersofthecrowd.

It is not surprising that insuch a situation an investormay rationally choose tomake the crowd’s beliefs hisownand join the informationcascade. He determines thatthe members of the crowdknow or understandsomethinghedoesn’tandthat

he will gain financially byadopting the crowd’sinvestment theme. Thiscrowd cascade can continueso long as the crowd’ssuccessful investment stancepersuades new investors tojoin.Butrememberthatmostmembers of the crowd havevoluntarily chosen to ignoretheirownprivate informationas they cascaded into thecrowd.Thisisatickingbomb

that will inevitably blow thecrowd apart. As soon as theinvestment performance ofthe crowd falters orconvincing, contradictoryinformation becomesavailable to crowd members,the cascade starts to run inreverse. At that point thecrowd’s members will nolonger weight the crowd’sbeliefs more heavily thantheir own. The investment

crowd disintegrates,vanishing like a wisp ofsmokeinthewind.

Here we reach the criticalpoint in our analysis ofinvestmentcrowds.Weknowthat a crowd built by aninformation cascade is afragile one. Information thatcontradictsthecrowd’sthemecan stop the cascade andcause the crowd todisintegrate. What kind of

information might be mosteffective in reversing thecascadeofnewmembersintothecrowd?Ithinktheanswerwill be obvious after a littlereflection. The crowd’sgrowth is fed by the successof the crowd’s investmenttheme.Withoutevidence thatprices are moving in thedirection predicted by thecrowd’s theme, the cascadewould stop. Prospective

crowd members would nolonger weight the crowd’sinformation more heavilythan their own.Themarket’saction itself can halt thecascade.

Butforthemarkettomoveagainst the combined buyingor selling power of aninvestment crowd, some sortof countervailing coalition ofspeculators and investorsmust develop. This can

happen only if the marketprice has been driven farenoughfromfairvaluebythecrowd’s activities to makeinvesting opposite thecrowd’s theme an attractiveand reasonably safeproposition.It is importanttonotethatitisn’tnecessaryforyet another crowd to form inoppositiontothefirstone.Allthat is required is that thedivergencebetweenpriceand

fair value created by thecrowd’s activities attractsenough value investors withan opposite view that themovement of price awayfromfairvalueishalted.

Because an informationcascade is so fragile, thegrowth of an investmentcrowdislikelytohaltassoonas the above-average returnstoitsinvestmentthemefailtomaterialize.Thiswill happen

as a natural consequence ofthe significant divergence ofthe market price from fairvalue that has resulted fromthe crowd’s investmentactivities.Andassoonas thecrowd’s growth stops, therewill then be a trickle ofmemberswholosefaithinthecrowd’stheme.Astheyleavethe crowd, the market pricewillslowlybegintodriftbacktoward fair value. At that

pointtheinformationcascadethatbuiltthecrowdwillbeginto run in reverse and thetrickle of disillusionedmembers will become aflood.

A market affected byinformation cascades and theinvestment crowds cascadesbuild will experience manyepisodes of significantovervaluation andundervaluation. The fact that

market prices fluctuate somuch more than can beexplained by long-termvaluation factors tells us onething: Cascade-inducedvaluation mistakes are therule, not the exception, infinancial markets. Thesemistakes are investmentopportunities for a contrariantrader.

How can the contrariantrader recognize an

information cascade in themaking? What clues shouldhe look for to detect anemerging investment crowdand the investmentopportunities it creates? Inthe next chapter we start toanswer these questions bybuilding a detaileddescriptionofthelifecycleofatypicalinvestmentcrowd.

CHAPTER5

TheLifeCycleandPsychologyofanInvestmentCrowd

Thecycleofbirthanddeath • cosmological

analogy • businesscompetitorsandvalueinvestors eventuallycausethedeathof thecrowd • once thecrowddisintegrates,anewcrowdoftenstartstoforminresponsetothe extendedmovement of prices •crowd formationcauses (and in turn iscaused by) excessive

price volatility •bearish crowds aredifferent from bullishones • the 1994-2000stockmarket bubble •stock marketvaluationandTobin’sq ratio • it’s differentthis time • the newinformation economy• shattered dreams •the bear crowd of2000-2002 • thequest

for certainty • theconflict betweenscienceandcertainty•every opinion has itsrationale • instinctualbelief • the need foraffirmation • piedpipers lead the crowd• mental unity ofcrowds • intoleranceof contrary views •examples from the1994-2000 bubble •

Julian Robertson,StanleyDruckenmiller, andGail Dudack • AllanSloan and AmericaOnline(AOL) •socialandfinancialpressureonunbelievers •pricevolatility andhomogeneousthinkingin crowds • pricevolatility is one signthatacrowdismature

PROLOGUE

In this chapter I collect thestrands of fact and theorywe’ve developed in thepreceding chapters. I willweave them into a tapestrythat chronicles the life anddeath of a typical investmentcrowd. Investment crowds

differ from one another innumerousdetails,buttheyalldevelop through the stagesdepicted on this tapestry. Tomake things as concrete aspossible,

I am going to use the stockmarket crowds of 1994-2002toillustratethetypicalpatternofaninvestmentcrowd’slifeand death.Once this cyclicalpicture of the life of aninvestment crowd is

completed, we will turn to astudyoftheinternallifeofaninvestment crowd. By this Imean the study of thepsychological attitudes ofthosewhojointhecrowdandthe nature of the individualrationalizations that permitthe information cascade todevelop.Knowledge of theseindividual patterns ofthinkingcanbeveryvaluablefor identifying information

cascades and the investmentcrowdsthatgrowfromthem.

THECYCLEOFBIRTHANDDEATH

How do investment crowdsgetstarted?Thereisnosingleright answer to this question.

But I think it is accurate tosay that most investmentcrowds find their genesis inthedeathsofotherinvestmentcrowds. I like to use a veryaptcosmologicalmetaphortohelp understand this process.Investment crowds are thestarsofthefinancialuniverse.The stars in the Milky Wayand in the much largercosmos have limitedlifetimes,whichtypicallyend

inamassiveexplosioncalleda supernova. But new starsare being born (i.e., startingtheir own process of nuclearfusion) all the time.What isthesourceofthematerialthatis the stuff of a new star?Well, it is just the cosmicdebris left by the explosionsofoldstars!

In much the same way,investment crowds burnbrightly in the financial

universe and are responsiblefor much of the observedprice fluctuation. But theyhave finite lifetimes (a fewmonths to a few years). Theinevitable disintegration ofany investment crowd causesabigrun-upordropinpricesand lots of commotion andconfusioninthemarketplace.Butthedebrisassociatedwiththe disintegration of a crowdis the stuff from which the

next crowd forms. Thechange in price associatedwith the disintegration of aninvestmentcrowdispowerfuladvertising. It attracts theattention of investors,especially of those whoseportfolios have been directlyaffectedby the rise or fall inassetvalue.

Let’s examine this processmore carefully. To keepthings concrete, you might

want to keep in mind as anexample the price of acommon stock or of somemarketaverage.

Imagine that a bullishinvestment crowd has driventheaverageorthestockpricewell above fair value. Everyinvestment crowd’s lifetimeis limited by the naturaleconomic forces of supply,demand, and competition.Once price is far enough

above fair value, willingsellersappearas ifoutof thewoodwork. New businesscompetitors arise, and theremay be a capital investmentboom in the relevantindustries. This shift insupplyconditionssteadiestheprice above fair value andeventually causes it to drop.The fragility of everyinformation cascadeguarantees that this process

will feedon itself,eventuallyleading to the completedisintegration of the bullishcrowd.

But this dramatic dropbacktowardfairvalueattractstheattentionofanothergroupof investors. The fear offinanciallossunitesthemintoa bearish crowd and leads tothe articulation of theirbearish investment theme.Their activities force price

well below fair value.Typically this is a verytemporary situation. Priceexcursions below fair valueare generally shorter indurationthanthoseabovefairvalue. Once the fear offinancial ruin dissipates,pricesreturnfairlyquicklytofair value. The movement isreinforced by the naturaleconomic forces if they havehadtimetooperateandifthe

bearish market mistake islarge enough. The return tofair value accompanies thedisintegration of the bearishinformation cascade and setsthe stage for the birth of anew, bullish investmentcrowd.

Now, the next bullishinvestment crowd does notformwhenpriceisbelowfairvalue.Insteadtheriseinpricefrom far below fair value

back toward fair valueadvertises a bullishenvironment. It is this pricemovement that stimulates thebirth of a bullish crowd.Some investors have hit thejackpotbecauseofthisrun-upinprices.Ifthisjackpotisbigenoughtoattracttheattentionof the media and of otherinvestors, a bullishinvestment crowd will form.The bullish crowd is most

likely to form at the pointwhere price has returned tobut is not yet above fairvalue.

We have before us acyclical picture of the self-reinforcing life cycles ofinvestment crowds. Thispicture offers an explanationof the connection betweeninvestment crowds andexcessive stock marketfluctuations and volatility.

Bullish and bearishinvestment crowds in turndrive themarket price aboveand then below fair value.Each such swing sets up theconditions that eventuallylead to the formation ofanother crowd with theoppositemarketorientation.

So far I have depictedbullish and bearishinvestment crowds prettymuchasoppositesidesofthe

same coin. It is tempting tobelievethatthereisapleasingsymmetry that controls theway both sorts of crowdsform,grow,anddissolve.Butasanyonewithexperience inthe financial markets willtestify, this isn’t true.Infact,thegrowthofabullishcrowdgenerally proceeds at amoreleisurely pace than does thegrowth of a bearish crowd.Bullish crowds last longer,

and the mistakes they forceupon markets tend to extendover longer periods of time.In contrast, bearish crowdsform and dissolve overrelatively short time spans,and themarketmistakes theycauseareforthemostpartofcomparatively short duration.The reasons for thisasymmetry are not very wellunderstood.Itmayarisefromthe fact that there is no

specific limit to how high apricemayclimb,butnopricecan drop below zero. In anycase, we will find that thisdifference between bullishand bearish crowds is itselfevidence pointing to theessential characteristic of allinvestment crowds: Theirmembers eventually behaveas a herd—a mass ofindividualswhosebehaviorisgoverned by instinct,

suggestibility, and imitation,notbyreason.

THESTOCKMARKETBUBBLE

OF1994-2000

Bullish investment crowdsgetstartedwhenthemarketistrading near fair value. The

birthofthecrowdistriggeredby the substantial advance inprices that occurred as themarket returned to fair valuefrom a position well belowfair value. The phenomenonis nicely illustrated by thebirthoftheinvestmentcrowdthatgaveusthestockmarketbubbleof1994-2000.

The stockmarket boomof1994-2000 in the UnitedStateswastheculminationof

an 18-year advance, anunprecedented bull marketthatbeganin1982.Atitslowin 1982 the Dow JonesIndustrial Average stood at777.On the final tradingdayof1994theaverageclosedat3,835, almost 400 percenthigher than in 1982. As themarket continued its advancein 1995, many expertsbelieved that the averageswere already trading well

above fair value and on thisbasis predicted an imminentcrash. Butwere prices reallyabovefairvaluethen?

As every investor knows,assessmentslikethisarehardto make. But I have foundthat, at least as far as long-term trends in theU.S. stockmarket are concerned, it isveryhelpfultoseekguidancefrom the famous q ratio,which was invented by the

Nobel Prize-winningeconomist James Tobin.Tobin believed that todeterminetheextenttowhichthe stockmarket is under-orovervalued, itmakessensetocompare the value the stockmarket places on corporateassetswiththecurrentcostofreplacing these assets (theirso-called replacement value).Itisthisratioofstockmarketvalue to replacement value

thatTobinchristenedq.

Thebestexplanationoftheq ratio I have found in printappears in the book ValuingWall Street by AndrewSmithersandStephenWright(McGraw-Hill, 2000). In itthey explain the q ratio andapplyit topracticalvaluationproblems. A simple synopsisof the theory behind the qratiogoeslikethis.Whenqissubstantially above 1.0 it is

cheaper to buy real assets,build factories, buyequipment, and startbusinesses than it is to buythesamestreamofincomeinthe stock market. Thus a qabove 1.0 stimulates a boomin real economic investmentand this leads to above-average economic growth. Aq below 1.0 means that it ischeapertobuyagivenstreamofincomeinthestockmarket

thanitistoearnitbymakingreal investments in theeconomy.Thusaqbelow1.0acts as a brake on theeconomy, or at least leads tobelow-average economicgrowth.

Thusone expects aq ratiosubstantially above 1.0 toaccompanyaneconomy-wideinvestment boom, whicharises because the stockmarketisovervalued.Insuch

a situation investors want tobuy capital equipment andform new corporations, thensell their interest in the stockmarket which values thisinterestwellaboveitscost.Incontrast,aqratiowellbelow1.0shouldbeassociatedwithweakdemandfornewcapitalgoods. The stock market issubstantiallyundervaluedandmaking real investmentsyields an instantaneous stock

market loss since the marketvaluesthematlessthancost.

Here is a remarkable fact:At the end of 1994, after anearly 400 percent rise instock prices measured fromthe1982lowpoint,Tobin’sqratio was just barely above1.0! Over the preceding 110yearsqhadvariedfromalowvalueof0.4toahighvalueof1.9. In 1994, q stood at 1.1.By contrast, in 1982 q stood

at 0.5, the lowest value seensince 1932 in the depths ofthe Great Depression. So wesee that, at least in terms ofTobin’s q ratio, a 12-year,400percentadvance in stockprices had only returned themarket to fair value by theendof1994!

This long advance hadmade a big impression oninvestors. To see how itchanged people’s thinking

about the stock market, Ihighly recommend readingBull!(HarperCollins,2004),abook by Maggie Mahar thatchronicles the stock marketboom and bust from 1982through 2002 in fascinatingdetail.

Maharreportsthatin1995,for the first time since theearly 1970s,U.S. householdsheldmorewealthinthestockmarket than in real estate. I

datetheemergenceofthebullmarket investment crowdfrom 1995. This crowd’sthemewasthatbuyingsharesin mutual funds and holdingthem was the sure way toamass wealth and achieveearly retirement. Theuniversal expectation of thiscrowdwas that stockswouldreturn10to20percentyearlyinperpetuity.Duringthenextfiveyearsmoneypouredinto

mutual funds. People whohad never invested in stockscommitted their life savingstothemarket.Theqratiorosefrom 1.1 in 1994 to anunprecedentedpeakof 2.6 inthe year 2000. The 2.6readingwasthehighestqhadeverbeeninthe120yearsforwhich data had beenavailable! It is not thensurprisingthatthe1998-2000period saw an enormous

capital goods boom, whichvastly increased capacity inthe telecom, computerequipment, and Internetservicesindustries.

The birth of thisinvestment crowd in 1995occurred when the stockmarket was priced at fairvalue, but only after a longrise in prices over thepreceding 12 years from alevel well below fair value.

This very powerful stimulusno doubt played a role indetermining this crowd’sunusual longevity and thesize of the mistake it forcedupon the market. That aside,this isaclassic illustrationofthe circumstances attendingthe birth of most investmentcrowds. But investmentcrowds can develop in otherways as well, and suchcrowds also played an

important role in the 1994-2002boomandbust.

IT’SDIFFERENTTHISTIME:THE

NEWINFORMATIONECONOMY

InChapter 4we saw that an

information cascade beginswhen some investors decidethat other investors knowmore about a particularinvestment opportunity thanthey do themselves. In suchcircumstances it can berational for a person toimitateanother’sactionsevenwhen his own privateinformation and proclivitiestug him in the oppositedirection.

So it is natural to expectthataninformationcascadeisespeciallylikelytodevelopinresponse to a genuinely newand different investmentopportunity, one that iscompletely outside the realmof most investors’ personalexperience. And this isexactly what is happeningwhenweheartalkaboutnewindustries and newtechnologies that promise to

revolutionize the economy.The unfamiliarity of the newinvestment opportunity canmake it difficult to tell if themarket price of an initialpublicofferingorofthestockofacompanyinanunfamiliarindustry is near fair value.Such circumstances make iteasy for business andinvestment cheerleaders toassert that the price is at oreven below fair value and

thus toencourage thegrowthofaninvestmentcrowd.

The 1994-2000 stockmarket boom wasaccompanied by apopularization of the phrasethe new economy. Thisreferred to the confluence oftrends toward globalizationon the one hand and thegrowing use of informationtechnology (embedded incommunicationandcomputer

equipment) to revolutionizethe way business is done. Inthe new economy,productivity growth wasthought tobeunusuallyhigh.Thispermittedhigheconomicgrowthandhighemploymentaccompanied by lowinflation, a situation thatGoldilocks herself wouldenvy.

The new economyenvironment of 1994-2000

not only encouraged thegrowth of the mutual fundstock market crowd but alsosupported the emergence ofsmaller investment crowds,which focused on particularindustries or companies.Since information technologywas supposedlyrevolutionizing economicrelationships, old thinkingabout the relationship of fairvalue to earnings potential

became suspect. Thesenewcomers to the corporateworld understood things thatold-time investors did not.Conditions were ripe for thedevelopment of informationcascades, and develop theydid. Soon investment crowdstook hold in the stocks ofcompanies like Amazon,America Online (AOL),Apple Computer, DellComputer,eBay,Enron,Intel,

Lucent Technologies, MCIWorldCom, Microsoft,Oracle, Priceline.com, QwestCommunications, SiliconGraphics, and Yahoo!, toname just a few. Thesetelecommunications and dot-com companies rocketed theNASDAQ-100 index to again of almost 400 percentfromlate1998toearly2000.

The very newness of thebusinesses these companies

saw themselves in made iteasy to convince normallyskeptical investors thattraditional valuationstandards no longer applied.As the resulting informationcascade gained momentum,the enormous amount ofmoneymadebyentrepreneursand early investors gaveaddedcredencetothistheme.Thatitallendedbadlyisjustthe ever-repeating story of

investment crowds and stockmarketinformationcascades.

SHATTEREDDREAMS:THE

BEARCROWDOF2001-2002

So farwehave lookedat thebirth of the bubble crowds

that formed during the stockmarketrun-upfromfairvaluein 1994 to extremeovervaluation in 2000.Thesebullish investment crowdsgrew from cascaded dreamsof a new economy. Whenthese bubbles burst, thecascade of dreams morphedinto a cascade of fear andrecrimination. This built thebear market crowd thatdominated the U.S. stock

marketduring2001-2002.

I have explained theprocess by which the typicalbearish crowd develops. Thedisintegration of thepreceding bullish crowdstriggers the birth of newbearish crowds. Thisgenerally happens only afterprice has returned to thevicinityoffairvalue.

Remember that the fair

valuepriceisonlyasignposton the road to the inevitableundervaluation that will beforced by the growth of thebearishinvestmentcrowd.

Where was fair value in2001 for the U.S. stockmarket? At the peak of thebullmarket in 2000, Tobin’sq ratio stood at a historicalhigh of 2.6, exceeding by averywidemarginitsprevioushigh of 1.9. The ratio was

clearly behaving differentlythan it hadover thepast 120years by leaving its normalrange of fluctuation between0.4 and 1.9. This posed aproblem for anyone trying touseq in real time,because itraisedmeasurementreliabilityissues. Perhaps the numbersused to calculate q didn’thave the same economicsignificance they had in thepast?

These uncertainties forcedme to temporarily abandon qas an estimator of fair valuefor the U.S. stock market in2001-2002. The q ratio mayyet prove to be of great use,but the jury is out on thecurrent significance of itsreadings to investors. Thissort of circumstanceillustrates the importance ofhaving multiple methods forestimating fair value. When

oneoranothermethodseemsto be out ofwhack for somereason, one has alternativemeasurement available. HereisasimplealternativemethodI like for estimating long-term fair value. It uses onlymarket price data, noteconomic data. As anempirical matter, the U.S.stock market has followed acycle of about 48 monthsfrom trough to trough over

theperiodthatbeganin1929.So as a rough-and-readyestimateoffairvalue,Iliketouse the 48-month, simplemoving average of themonth-end reading of theS&P500stockmarketindex.(Recall that this movingaverage is computed byadding up 48 consecutivemonthly closes and dividingthe answer by 48.) The 48-month length of the moving

average is selected tominimize the effects of thenormal 48-month rhythm isstockprices.

Let’s get back to the storyof the 2001-2002 bearishinvestment crowd. In March2001theS&P500touchedits48-month moving average,my long-term estimate forfair value, for the first timesince 1982. The index hadtraded above this fair value

estimate for more than 18years! The moving averagestood at roughly 1,210 inMarch 2001, and the indexitself dropped to 1,084 thatsame month and then ralliedto1,315byMay2001.

The return to fair valuefromapointofovervaluationwill leave investors withlosses.Indeed,newspaperandmagazinecommentaryduringlate2000andearly2001held

unanimouslythatthedot-comand technology bubbles hadburst. This event wasdramatically recorded by theNASDAQ Composite stockmarket index, home to mostof the bubble stocks. At its5,132 high in March 2000,this index was trading morethat 150 percent above fairvalue asmeasured by its 48-month moving average. Oneyear later the NASDAQ

Composite had dropped aslow as 1,619, about 35percent below the movingaverageestimateoffairvalueat the time and a stomach-churning 69 percent dropfromitshighayearearlier.

The shock of a 69 percentdrop in the technologysectorwas transmitted instantly toinvestors, because they hadpoured money intotechnology mutual funds

during the 1999-2000 bubbleyears at unprecedented rates.The natural response to suchdestructioninportfoliovaluesisfearoffurtherloss,asearchformeans of escape, and theidentification of scapegoatsand evildoers to be heldresponsible for the damage.These are the potentingredients from which thethemeofnearlyeverybearishinvestment crowd emerges.

Bearish crowds tend todevelopquicklybecausemostmembers already haveexperienced financial loss.The information cascade thatdevelopsonthesefoundationsgives new members of thecrowd reason to fear thatmore erosion in asset valuesliesahead.Suchpersuasioniseasily accomplished. It relieson the universal conventionthatguidespeopleinmarkets

andinlife:Tomorrowwillbeprettymuchliketoday.Butinthe case of a bearishinvestment crowd, today isfilled with financial pain.Tomorrowcanonlybeworse,especiallybecause thecrooksresponsible for the currentdistress have not all beencaught. Themeans of escapebecomes obvious: sell. Onceaninvestorhassoldout,heiseven more convinced that

worse is to come in themarket, for otherwise hisactionswillappearfoolish.

I will discuss the 2001-2002 bearish stock marketcrowd in more detail insubsequent chapters. Sufficeto sayhere that bymid-2002it had become a very visibleand dominating investmentcrowd. By that time theNASDAQ Composite indexwas trading more than 50

percent below its movingaverageestimateoffairvalueand nearly 80 percent belowits 2000 high. The S&P 500wastrading38percentbelowits fair value estimate, downabout 50 percent from its2000highat1,553.

POPULARINSTINCTSAND

THESEARCHFORCERTAINTY

As a bullish crowddisintegrates, price dropsbacktowardfairvalue.Whenabearishcrowddisintegrates,price rallies upward towardfairvalue.Inbothinstancesabig, unexpected price changeadvertises the death of thecrowd. It also attracts the

attention of the rest of thefinancial world. People ask,“Why did prices drop somuch?” They wonder, “Howcomethemarketralliedsofarinthefaceofbadnews?”

Investors always wantanswers. In this respect theyaresimplybeinghuman.Itisman’s inclination to ask andto answer the question whythat distinguishes him fromanimals lower in the food

chain.Scientistsgrapplewiththewhy question every day.That’s their business.But, asevery scientist knows, themostpowerfuldevicehumanshave invented for gettinganswers, the scientificmethod,requiresasuspensionof judgment about thisanswer or that one. Insteadthescientistproposesatheoryto explain observed eventsand then carefully compares

it with the empiricalevidence.Sometimesthedataprove the theory is plainwrong.Or, ifheis lucky, thescientist might find that thedata are entirely consistentwith the theory’spredictions.But these outcomes are notcommon. Usually thecomparison of data withtheoretical predictions has anambiguous result, so thescientist must go back to his

desk or lab to reconsider hisideas and research strategy.The shipof scientific inquiryspends little time near theshelteredshoreofcertainty.

In their everyday affairspeople do not use thescientific method to explainevents.Theyhaveneitherthetimenortheskill.InhisbookInstinctsoftheHerdinPeaceand War (orig. pub. 1919;reprintedbyCosimoClassics,

2005), the London surgeonand sociologist WilfredTrotter observes: “In mattersthat really interest him, mancannot support the suspenseofjudgmentwhichsciencesooftenhas toenjoin.Heis tooanxioustofeelcertaintohavetime to know.” With littletime to know (i.e., to applythe scientific method) and alow tolerance for ambiguity,the typical investormust rely

more on instinct than onscience to explain marketmovements.

What do I mean by theword instinct? Nowadayspsychologists andsociologistsdon’tbelievethatany human behavior isinstinctual in a narrowtechnicalsense,thatis,inthesame sense that certainanimal behavior may bedescribed as instinctual and

biologically based. But Ithink this term can still beuseful in describing thenature of rationalizationspeople use to explain theirbeliefs and actions. This ispreciselythewayTrotterusesit in his book. He citesVolume2ofWilliamJames’Principles of Psychology(1890, reprinted by DoverBooks in 1950 and availabledigitally on the Internet) to

explain how instinctualbehavior in Trotter’s senseappears to humanintrospection. He defines aninstinctive action or belief asoneappearingsogroundedincommon sense that any ideaofdiscussingitsbasisappears“foolish or wicked.” Aninstinctualactionisobviouslythe right thing to do. Only afoolish or ill-intentionedpersonwoulddaredisputean

instinctualbelief.

Of course instinct in thissense is not a biologicalphenomenonandso isunlikeanimal instinct. Instead it isanalogoustoareligiousbeliefor a belief that is axiomatic,basedonassumptionsthatarenever questioned. Instinctualbeliefs in Trotter’s senseoften arise when peopletransfer theirexperiencesandbehavioral responses and

beliefs from one realm ofactivity to another. But aneven more importantmechanism for belieftransmission and acquisitionis the social group and thecrowd.

People prefer the comfortand certainty of instinctivebelief to the ambiguityassociated with scientificprocedure and knowledge.Trotter points out that in

everydaylife:

[individuals] makevast numbers ofjudgments of a veryprecise kind uponsubjects of very greatvariety, complexity,anddifficulty....Thebulk of such opinionsmust necessarily bewithout rational basis. . . since they areconcerned with

problems admitted bythe expert to be stillunsolved, while as totherestitisclearthatthe training andexperience of noaverage man canqualify him to haveany opinion uponthematall.

Trottercontinues:

Itisclearattheoutset

that these beliefs areregarded by theholder as rational,anddefendedassuch,while the position ofone who holdscontraryviewsisheldto be obviouslyunreasonable.

To be sure, no one I haveevermethasadmittedthathisbeliefs are for the most partinstinctual in this sense. Far

from it. We all think ourbeliefsarerational,oftenself-evidently so. Trotter notesthisphenomenon:

[I]t should beobserved that themind rarely leavesuncriticized [its]assumptions . . . thetendency being for itto find more or lesselaboratelyrationalized

justification for them.This is in accordancewith the enormouslyexaggerated weightascribed to reason inthe formation ofopinionandconduct.

If most of our beliefs areinstinctual, it is natural towonder about their source.How do such beliefs arise?How do we acquire them?Certainly some are

generalizations fromindividualexperience.Butweallholdbeliefsaboutpolitics,national affairs, economics,local affairs, sports, and soforth,andtheserealmsareforthe most part outside of ourpersonalexperience.

Most of our beliefs andtheir rationalizations areadopted from the socialgroups in which weparticipate.We take the very

fact that many people whomweknowholdthesebeliefstobeevidencefortheirvalidity.This mechanism for beliefformation has something ofthe flavor of an informationcascade.But todescribe it incascade terms ascribes toomuch rationality to theprocess of belief acquisition.Trotter expresses this sameideamorecolorfullywhenhecomparessocietytoaherdof

animals, but a herd endowedwith a voice, a power ofsuggestion:

[B]elief inaffirmations . . .sanctionedbytheherdis a normalmechanism of thehumanmind,andgoeson however muchsuchaffirmationsmaybe opposed byevidence. . . .

[R]eason cannotenforce belief againstherd suggestion. . . .[T]otally falseopinionsmayappear.. . to possess all thecharacters ofrationally verifiabletruth.

Thisisnottosaythatallorevenmost of our beliefs thathaveapurelysocialbasisarenecessarily wrong or

irrational. Indeed,scientifically verifiablebeliefs often acquire thesanction of the herd, thecrowd, or the social groupand are thus transmitted tothosewho have no access toor understanding of thescientific method. Thissanction generally takes agenerationormoretoacquire,but one need go no furtherthan the examples of

Darwin’s theory of evolutionorEinstein’s relativity theoryto see this process in actiononalargescale.

THEPIEDPIPERSOFINVESTMENT

CROWDS

Thedrop in themarket price

back to fair value during thedeath of a bullish crowd andthe rise in price back to fairvalue during the death of abearish crowd generallyattract a lot of attention.Investorswantanexplanationofadramaticandunexpectedprice change. This demandfor explanation naturallycreatesitsownsupply.Ilikenthe rationalizations thatemerge in these situations to

the Pied Piper of Hamelin.The rationalizations rarely ifeverhaveanyscientificbasis.Instead,themusicofthepipefirstattractsattentionbecauseit sounds like a plausible,indeedlogical,explanationofanotherwisemysteriouspricemovement. The reasoningappears instinctually obviousto its growing number ofadherents.But eventually thepiper exacts a toll from his

audience, a price that farexceedsthefewcoinsrationalcalculation would haveoffered. The investmentcrowdfollowsthepipertoitsinevitable doom broughtaboutbytheeconomicforcesthat limit the size of marketmistakes.

During the big move incrude oil prices from $40 in2004 to $140 in 2008, thepiedpiperofpeakoil played

a very seductive tune. Peakoil advocates asserted thatworldproductionofcrudeoilwas bound to start aninevitable decline for purelygeological reasons early inthe twenty-first century. Theobvious conclusion was thatcrude oil prices had nowhereto go but up. Other theoriescompeting with peak oilreinforced expectations of asteadyupwardmarchincrude

oil prices. One of these wasthattheacceleratedeconomicgrowth in China and Indiawas creating unusual andexpanding demand for allnatural resources,not just foroil. Another was the deviltheory of markets, whichattributesallbigmovestothemachinations of speculators.Here were three pied pipersthatenabledthebullishcrudeoil crowd to grow to

enormoussizebymid-2008.

The new economy bubbleof 1994-2000 had its ownpied pipers. This bubbleinflated on the basis of thenew information economy,the acceleration ofglobalization, and theassociated rise inproductivity. Demand fortelecom bandwidth was saidto be unlimited. The Internetwas to provide a whole new

business model in whichprofits played but a smallrole.Oneinterestingaspectofthe bubble was thatmany ofthe pied pipers were actualpeople. They had nameseveryone in the bubblecrowds recognized: JackGrubman, Frank Quattrone,Abby Joseph Cohen, MaryMeeker, Henry Blodget,Maria Bartiromo, RalphAcampora, and Alan

Greenspan.

The bear crowd of 2001-2002haditsownpiedpipers,but they were not as plainlyvisible as the ones that hadenabledtheprecedingbubble.The bear crowds that formamidst thedebrisofabubbletypically blend thecharacteristics of lynchmobsand repentant sinners: Wehaditcomingforbelievinginthe patent nonsense of the

bubble investment themes;theyledusastrayandcheatedus, and now they must paytheprice.Thecrowdsearchesfor scapegoats, and those itfinds become inverted piedpipers, repelling listenerswith the dissonant music oftheir pipes. They are offeredasexemplarsofunsoundandeven stupid investmentpolicies. This process oftearing down the edifice of

belief that supported thebubble continues until onlydiscouragement and fear forthe future control investorattitudes.

THEMENTALUNITYOF

INVESTMENTCROWDS

So far we have seen thatinvestmentcrowdsgetstartedafter themarket price returnsto fair value following asignificant excursion awayfrom fair value. The pricemovement that arises fromthereturntofairvalueattractspublic attention. Investors’human aversion to ambiguityanduncertainty,coupledwiththeir limited capacity forscientific thinking, leaves

themvulnerabletopiedpiperexplanationsfortherun-uporthe drop in prices. Theseexplanations are alwaysplausibleandexhibitacertaininternal logic. This is whatmakes them seductive tunesfor the pied piper’s pipe. Ifthe tune promises asignificantcontinuationoftheprice move that has alreadybeen observed, then aninvestment crowd will be

bornandstarttogrow.

Now we will discuss theview from inside adevelopinginvestmentcrowd.How do people in a crowdact?How canwe distinguishan investment crowd fromany random group ofindividuals? I am going tooffer my own answers tothese questions, butmuch ofwhat I saycanalsobe foundin Gustav Le Bon’s 1895

classic The Crowd. Theanalysis of crowdmotivationandbehavioryoucan find inhis book makes it requiredreading for any contrariantrader.

The most importantcharacteristicofanycrowdiswhatGustavLeBoncallsthecrowd’s mental unity. Theattentionandsentimentsofallcrowd members are focusedin a single direction or on a

single phenomenon. Thementalunityofaninvestmentcrowd is externallymanifested in the crowd’sinvestment theme. Aninvestment theme is a basketof explanations and of theforecaststhatseemtobetheirobvious consequences. Aninvestment theme identifiesan asset or a class of assets,andexplainswhythepriceofthese assets has changed so

much recently (during thereturn to fair value) andwhypricewill continue tochangein the same direction. Thepied pipers of the financialworldaretheearlyadvocatesof these investment themes.We have already seenexamples of investmentthemes:thosethatunifiedthebubble crowds of 1994-2000andthebearmarketcrowdof2001-2002.

An investment themebegins to attract adherents asits true believers publicizetheirviewsandasthemarketpricecontinuestomoveinthedirection they forecast. Thisis the beginning of aninformation cascade.Newcomersarepersuadedbythe arguments of the truebelievers to ignore their owninformation(iftheyhaveany)and accept the information

upon which the cascadebuilds. The mental unity ofthe crowd begins itsdevelopmentinthisway.Butthere is much more to acrowd’s mental unity thansimplyitsinvestmenttheme.

Theessenceoflifewithinacrowd is constantreinforcementandaffirmationofthecrowd’sbeliefs.Crowdmembers communicate withoneanother,eitherdirectlyas

individuals or indirectlythrough the print andelectronic media. Crowdleadersarealwaysvisibleandalways courting publicity.They never forgo the chanceto “talk their book,” to urgenewcomers to accept thecrowd’sinvestmenttheme.

This constant repetition ofa crowd’s investment themeis the single most importantcharacteristicoflifewithinan

investment crowd. Lifewithinanycrowd(notjustaninvestmentcrowd)is likelifewithin an echo chamber. Allonehearsisarepetitionoftheinvestment theme andconfident pronouncementsaboutprofits tobe earnedbyits followers. Soon even thelogic supporting the theme isforgotten—or reduced toeasily remember cliché. Themere fact that crowd

membersexperiencesomuchaffirmation of their belief(albeitonlyfromothercrowdmembers) is taken as moreevidenceofthecorrectnessofthecrowd’stheme.

Both Le Bon and Trotterobserve that the affirmativemessages that build crowdunity are not usually appealsto the intellect of crowdmembers. Instead they areappeals to emotion, to

stereotypes, to dreams orfears. The language ofpersuasion and crowdsolidarity is the language ofdrama,notscience.

Affirmation and repetitionbuild the mental unity of aninvestment crowd. As thecrowd’s mental unitydevelops, members of thecrowd begin to resemble oneanother in their preferences,beliefs, and actions. Crowd

memberssenseanincreaseinthe power of the crowd, andthisencourageseachof themtobemoreofarisktaker.Ofcourse what an outsiderwould identify as a riskierinvestment stance the crowdmembers see as very safe,almost a sure thing. Crowdmembersgivelittlethoughttothe consequences of beingwrong. Such a discussionwould not be sanctioned by

the crowd, and doubterswouldbe cast to the crowd’sfringesorexpelled.

I have found a crowd’sintolerance of contrary viewsto be its single mostimportant identifyingcharacteristic. Thisintoleranceshowsitselfintheformofridiculeandabuseofanyskepticalconsiderationofits theme. I have written aninvestment blog

(www.carlfutia.blogspot.com)forseveralyears.Itrytotakethe viewpoint of a contrariantrader. When the commentson my blog are the mostnumerousandabusiveIknowthat a market turn isimminent.

Crowd intolerance ofcontrary views can manifestitself inother,moredramaticways in the world of assetmanagement by mutual

funds, pension funds, andhedge funds. Moneymanagerswhodonotjointhecrowdrunasignificantriskofbeing fired or put out ofbusiness. The same fate canbefall any investment guruwho dares cross the crowd.Both these sorts of thingshappened indramatic fashionduring the late stages of the1994-2000 stock marketbubble.

Founder Julian Robertsonclosed the investment firmTiger Management in March2000, right at the top of thestock market bubble. He didextraordinarily well for hisinvestors, earning an averageannualreturnnetoffeesof25percent during 20 years. Butthe bubble year of 1999washis undoing as his funddropped19percentwhile theS&P500rose21percent.His

investment method couldn’taccount for the bubblecrowd’s massive buyingpower.Hispoorperformancein 1999 would have causedhis investors to abandon himin droves had he not shutdown his firm when he did.So one of the most talentedhedge fund managers of hisgeneration was forced out ofbusinessbytheactionsofthebubble crowd, whom he had

chosentoignore.

If you have a taste forirony, youwill find the sagaof Stanley Druckenmillereven more intriguing.Druckenmiller ran a goodpartofGeorgeSoros’shedgefund, the Quantum Fund,from 1988 through 2000.Hewas and is an enormouslytalented investor. But like somany experienced investors,he did not participate in the

late 1990s technology boom,believing that it would cometo no good end. Thisreluctance began to hurt theQuantum Fund as itsinvestors questioned thewisdomof stayingoutof thetechnologysector.

During the summer of1999 Druckenmiller had anepiphany about the techsectorwhilehewasattendingan investment conference.

Upon his return he put theQuantum Fund into many ofthe technology stocks thatwere rising dramaticallyduringthelatterhalfof1999,the terminal stage of theNASDAQCompositeindex’s400 percent rally from its1998lowpoint.TheQuantumFund’s performance duringthe latter half of 1999 wasoutstanding. Sadly,Druckenmiller’s tech

portfolio was buried by thedramatic sell-off duringMarch-May2000,whichwaseventually to bring theNASDAQ down 80 percentfrom its 2000 high. Thissetback led toDruckenmiller’s departurefrom the Quantum Fund andto Soros’s temporaryshutdown of the fund’sspeculativeactivity.

The stories of these two

talented investors, Robertsonand Druckenmiller, illustratewell the fate of moneymanagers who don’t alignthemselves with dominantinvestment crowds. Thecrowdwill abandon even themosttalentedmanagerifheisnotcommittedtothecrowd’sinvestment theme. Everymanager knows this, and allunderstand the risk of beingputoutofbusinessforfailing

to toe the party line in theirportfolios. This of coursereinforces the influence ofany investment crowd. Theirony of StanleyDruckenmiller’sexperienceisthat he bent to the crowd’spressure at precisely thewrong time. The resultingportfoliowhipsawseveredhisrelationship with theQuantumFund.

The story of Gail Dudack

and theTVshowWall$treetWeek also illustrates thepower of an investmentcrowd toharm the careersofthosewhooppose it.Dudackwas chief market strategistduring the 1990s at thebrokeragefirmS.G.Warburg.Like so many experiencedmarket watchers, Dudackrecognized the stock marketbubbleforwhatitwas,andinlate 1997 she announced her

bearish views to her clients.Shewas also a regular gueston Wall $treet Week withLouis Rukeyser, a verysuccessful weekly TV stockmarketshowproducedforthepublicbroadcastingaffiliates.By November 1999 herbearishviewshadsoirritatedLouis Rukeyser, the show’spopularhost,thatheremovedDudack from his list ofregular guests and from her

slotinhisElvesIndex,ajointmarket assessment of thetechnical analysts whoappearedonhisshow.

Rukeyser was in thebusiness of attractingviewers, and as everyone inthe entertainment businessagrees, the way to do this isto give people what theywant. By 1999 the bubblecrowds had grown sointolerant of contrary views

that Rukeyser felt compelledto throw Dudack under thebus.

Herewehavebeforeustheexperiencesoftwoprominenthedgefundinvestorsandoneprominent market strategist.All three fell before theintolerant onslaught of thebubblecrowdduringthebriefperiod from November 1999throughMay2000.Itisnotacoincidence that all the stock

marketaveragesreachedtheirhighsinJanuary-March2000.

It isnot surprising that theintolerance of investmentcrowds can affect financialjournalists as well. In 1995and 1996 Allan Sloan, afinancial columnist atNewsweek, wrote severalcolumns expressing hisskepticism about theaccounting methods ofAmerica Online (AOL), a

company that pioneered thecommercializationof Internetconnectivity. AOL’s stockhad soared since its initialpublic offering in 1992, andSloanbelievedittobegrosslyovervalued. Needless to say,his skeptical views were notwelcomed by the investmentcrowd,whobelievedinAOL.Heeventuallystoppedwritingabout AOL, which, withexquisite timing, reached a

merger agreementwith TimeWarnerinthespringof2000.Why did he stop? MaggieMahar quotes Sloan in herfascinating book Bull!(HarperCollins, 2004),whichchroniclesthebubble:

IknewIwasright,butwhenever I publishedone of those stories,everyone would carryon. . . . Finally I justgave up. I shouldn’t

have,but Idid.Thereare only a limitednumberof swingsyoucan take—eventuallyyoulooklikeacrank.

The social and financialpressureaninvestmentcrowdcan exert on disbelieverscannot be overestimated.While much of a crowd’sgrowthoccursastheresultofan information cascade, thecontinuousstrengtheningofa

crowd’smentalunitythroughconstant affirmation,repetition,anddramaticpricechanges in the crowd’s assetmakes this unity a powerfultool of persuasion. Itmagnifiesthecrowd’simpactand importance and putspressureoneven theskepticstojoin.

SUGGESTIBILITY,

VOLATILITY,ANDDISINTEGRATION

As the mental unity of aninvestment crowd growsadherents to its investmenttheme become homogeneousin their thinking. When thishappens the crowd developsan important characteristicthatmaturecrowdssharewithherdsofanimals.Itsmembers

becomeverysuggestible,andare apt to take action ormodify their beliefs whenpresentedwithastrongimageof something they desire orfear. Suggestibility opposeslogicalpersuasion,but,aswehave seen, every crowdmember so strongly believesin therationalizationsofferedby the crowd that no logicalpersuasion is necessary.Consequently, images

presented to thecrowdby itsleaders or the media will beacted upon immediately bymembers of the crowdwithoutfurtherquestioning.

This is theessenceofherdbehavior. The members of aherd find safety in numbersbut only so long as the herdstays together inagroupandacts together as well. Aninvestment crowd holdstogether only so long as the

price of its asset(s)moves inthe direction expected by thecrowd. But this can happenonly if crowd membersrespond almost instantly tothe appropriate images andtheirimpliedsuggestions.

A fascinating example ofthe suggestibility of stockmarket crowds developedduring the late stages of thestock market bubble in thelate 1990s. Companies with

“.com” in their names werepriced at a premium by themarket, and several weremotivate to change theircorporate names for thisreason. Of course, no valueperseresidesinamerename,but the image of a dot-comcompany was stronglyassociated with stock marketprofits.Thismadeeverysuchstockafavoriteofthebubblecrowds of the late 1990s.

Similar things happen ineverystockmarketboomandillustrate the important rolethat images play ininvestmentcrowds.

Once an investment crowdbecomes herdlike in itsbehavior,thepriceofitsassetbecomesmuchmorevolatile.Where once daily pricemovements up or downseemednormalinmagnitude,one instead sees daily price

fluctuations in much widerbands. The market seems tosoar or tumble with littlerhyme or reason, and everytidbitofnews,relevantornot,hasanexaggeratedeffect.

A dramatic increase inprice volatility is one of thesigns that an investmentcrowd has reached maturityand that the informationcascadesupportingthecrowdhasbecomeveryfragile.With

membersofthecrowdattheirmost suggestible, willing toaccept both hopeful andfearful images at face value,every new bit of informationhasanexaggeratedimpactonthe crowd and on themarketprice. Because price hasbecome so volatile, themessages crowd membersthink they see in pricechanges will have evermorepowerful effects on their

willingness to stick with thecrowd’s theme.Anynegativenews, even if not associateddirectly with the crowd’stheme, can bring down itsinformation cascade becauseit may trigger significantselling or buying of thecrowd’s asset, perhaps byinvestors outside the crowd.Thecrowd’ssuggestiblestateguarantees that such pricemovements are highly likely

to snowball as members ofthe crowd successively takeflight.

While dramatic increasesinpricevolatilityaresignsofa mature investment crowd,the increased fragility of itsinformation cascade alsomeans that the disintegrationof the cascade is almostimpossibletopredictaheadoftime. In subsequent chapterswewill take a closer look at

theproblemofidentifyingtheimminent disintegration ofinvestmentcrowds,aproblemthat every contrarian tradermustbeabletosolve.

CHAPTER6

TheHistoricalContextforMarket

Mistakes

Exhausted investmentthemes•clues thatan

investment crowd ismature • look for themarket mistake •marketmistakesinthecontext of themarket’shistory•onlyneed a guesstimate •lookatmarket’spricehistory and then atmedia content • thismethod focusesdirectlyon themarketmistake, not on fair

value itself • pricehistory more usefulthan estimates ofearnings • regularityin emotional behaviorof crowds • datasources for historicalprices • beginners’mistakes • how toidentifyastockmarketbubble • examples of1929,1966,and2000• how to identify

undervaluation in thestock market •examples ofundervaluation • thepeakoilbubble

MATUREINVESTMENTTHEMESAND

MARKETCROWDS

Every contrarian trader mustlearn how to identify thepoint atwhich an investmentthemehasexhausteditself.Atthis juncture the informationcascadehasdoneitsworkandthe market commitments ofthe investment crowd havegrown about as large as islikely based on historicalprecedents. The associatedmarket crowd has reachedmaturity and is nearing the

disintegrationassociatedwithold age. The crowd hasforced the market to make avaluation mistake. Pricestands well above or belowfair value. Soon economicforces and sharp-eyed valueinvestors will begin theprocess of correcting themarket’s mistake. Once thisprocess begins, the crowdwill disintegrate and pricewill return rapidly to fair

value, sometimes continuingwell past that point toproduce another valuationmistake in the oppositedirection. This return to fairvalue is the investmentopportunity that a contrariantrader seeks toanticipateandexploit. For this reason thecontrarian trader must bealwaysvigilant,alwaysonthelookout for matureinvestment themes and

investmentcrowds.

Are there any clues thatcan warn us that a marketmight be the hands of amature investment crowd?Since mature crowds forcemarkets tomakemistakes, totradewellaboveorbelowfairvalue,itmakessensetotrytoidentify these marketmistakes directly. I believethateverymarketmistakecanbeidentifiedbyputtingitinto

the context of the market’shistoricalpricefluctuations.Iwill explain the kind ofcomputations needed toidentifythiscontext.

Ofcourseanysuchmethodwill at best yield onlyapproximate answers. Butthis is not a problem for thecontrarian trader. Hisassessments of whether themarket is over- orundervaluedwillbeonlyone

input to his decisionprocess.He only needs theseguesstimates about possibleover-orundervaluationtogethim into the right valuationballpark, to indicate thepossibility that a maturemarketcrowdmaybecausingavaluationmistake.

In this chapter I want toshow you how to identifysituations in which a marketmay be trading significantly

above or below fair value.The novel aspect of themethodsIexplainisthattheyuse only the market’s pricehistorytoestimatethecurrentposition of fair value. Noinformation about pastdividends or profits orestimatesof theirprospectivelevels is needed. In a sensewewillbeextractingfromthemarket’s price historyinformation about how fair

value changes over time, aswellasinformationaboutthesize of typical marketmistakes. Using thisinformation,wewillcomputea rough estimate of thecurrentfairvalueprice.

Locating price relative tofairvalueisonlythefirststepin the process of spotting apotential contrarian trade. Insubsequent chapters I willshow you how to combine

this valuation informationwith an analysis of mediacontent.Thestoriesappearingin the electronic and printmedia give you a way toobserve information cascadesastheyproceedandtoassessthe strength of associatedmarket crowds. It is thecombination of a potentialvaluation mistake togetherwith solid, affirmativeevidence that this mistake is

caused by a mature marketcrowd that is the key to aprofitablecontrariantrade.

MISTAKESVERSUSFAIR

VALUE

InChapter5Iexplainedwhythedisintegrationofabullish

investment crowd usuallyresults in thebirthofbearishone,andviceversa.Thecycleof alternating bullish andbearish crowds is a universalfeature of financial markets.This cycleofbirth anddeathis responsible for themistakes markets make—forprices being alternately toohighandthentoolowrelativetofairvalue.

Butwhatisfairvalue?We

have already seen thateconomists compute the fairvalue price of an asset bydiscountingtothepresenttheestimatesoftheasset’sfuturecash payouts (dividends inthe case of common stocks).Sadly, this wonderfultheoreticalconceptisnotveryuseful as a yardstick for thecontrarian trader. I havefounditmoreuseful to try toidentify market mistakes

directly instead of focusingmy attention on estimates offairvalue.Infact,Ithinkthiscan be done by studying amarket’s historical pricebehavior.Whymight this beso? The market prices weobserve result from theconfluence of two kinds ofinvestment activity. The firstarises from a rationalcalculationofvaluebasedonpurely economic and

statisticalconsiderations.Thesecond arises from thepsychological and emotionalcharacter of investmentcrowds and informationcascades. I think the lattershows far more regularitythan the former. Moreover,this regularity inpsychological and emotionalbehavior is very difficult toexploit, because the typicalinvestor is a part of this

phenomenon, not apart fromit.Sowewouldexpecttoseesuchregularityshowingmorepersistence instead of beingdestroyed by the few traderscapableofexploitingit.

ThemethodIhaveadopteduses historical price data toidentify situations in whichthe market is tradingsignificantly above or belowfair value. It does this bytabulating the extent and

durationofamarket’stypicalswings fromhigh to lowandlow to high. My workinghypothesisisthatathistoricalhigh points the market wasovervalued and at historicallow points it wasundervalued. I expect to seeconsistency in the durationand the extent of the swingsfrom undervalued toovervalued conditions andbackagain.Suchconsistency

I regard as an empirical factabout the psychological lifecycle of crowds. As such, itshould be quite independentof the specific economicenvironmentofthetime.

Because this method restson empirical estimates of theeffects of crowd psychologyon markets, it can beexpected to work only if amarket has enoughparticipants to support the

formationoflargeinvestmentcrowds, especially crowds ofpeoplewho are not normallyattentivetofinancialmarkets.For this reason this approachworks best with the stockmarket averages, the bondmarkets, and somecommodity markets (thosethat attract public attention).It is much less useful inestimating when the price ofanindividualstockishighor

lowrelativetofairvalue.

MARKETDATASOURCES

BeforegoingfurtherIthinkitis useful to identify somesources for the market datathat you will need to do thecalculations I will describe.Thesesourceshavechangeda

lotduringthe40yearsIhavebeen participating in thefinancial markets. Years agoyou had to collect this datafrom newspapers, or, if youwere lucky, you might havebeenabletopurchasesomeofit already tabulated fromsome obscure source youhappened to hear about. Butnowadays computers and theInternet have made the pricedata aspect of contrarian

trading so much easier. TheInternet has become atremendously useful datarepository for the contrariantrader. Having computationalpower at hand on yourdesktop is a tremendouslaborsaving device whenanalyzingthisdata.

At present there is nosingle comprehensive datasource for the informationyou will need, but as

computing power andcommunication resourcesexpand I expect this tochange over the next 10years.WheneverIneeddataIdon’talreadyownIoftencanlocate a source by usingGoogle or some other searchengine.Here are threeonlinedatasourcesthatIhavefoundvery valuable. They will nodoubt be either outdated ordefunct in a few years. No

matter.Iamsureyouwillstillbe able to use online searchtools(likeGoogle)toidentifynewdatasources.

The first one is Yahoo!Finance(http://finance.yahoo.com).This data is comprehensiveand free! Once you haveidentified a stock or stockmarket index, Yahoo! offersaccess to daily, weekly, ormonthly historical data,

which can be downloaded asan Excel spreadsheet. Excelitselfhaschartingcapabilitiesthat you can use for apreliminarydataanalysis.

Thereareanumberofsitesthat offer downloadable datafor stocks, stock marketindexes, currencies, andcommodities on asubscription or one-time-purchase basis.Here are twoof the most widely used:

Commodity Systems Inc.(www.csidata.com) andMetaStock(www.equis.com).

THEDEADLYMISTAKE

The goal of every contrariantraderistobeatthemarket—to earn an investment returnthatexceedsthereturnearned

by thebuy-and-holdstrategy.(Sophisticates might want tomakeappropriateadjustmentsfor portfolio risk whenmaking this comparison.)There is only one kind ofmistake a contrarian tradercan make that will preventhim from matching orexceeding the buy-and-holdreturn: being out of or evenshort the market when itrising. (Being fully invested

when the market is fallingdoes no harm to hisperformance relative to buy-and-hold.)

Sadly, it is precisely thismistakethatnovicecontrariantraders are most prone tomake.Why?Ithinktherearetwo reasons.First,periodsofmarket overvaluation tend tobe of longer duration thanperiods of undervaluation, sothere is simply a lot more

opportunitytomakethiskindor error. Second, there ismuch more variability in thesize of the mistake a marketcan make in the direction ofovervaluation. These twofactorsworktogethertomakethetaskofidentifyingperiodsof overvaluation much moredifficultandmuchmoreriskythan the task of identifyingperiods of undervaluation.Combine the technical

difficulty of identifyingperiodsofovervaluationwiththe novice’s eagerness toshowtheworldhowcleverheis, and you have a reliablerecipefordisaster.

I am convinced that thedifficulty of identifyingperiods of marketovervaluation means that thecontrarian trader, especiallythe novice, should focus hisefforts on identifying and

exploiting periods of marketundervaluation. I’ll havemoretosayabout thismatterin Chapter 11, in which Idiscuss “The Grand StrategyofContrarianTrading.”Inthemeantime, I think theway toproceed is to adopt anasymmetricalapproachtothisproblem by developingcriteria for identifyingovervaluation that are morestringent than those for

identifyingundervaluation.

WHENISTHESTOCKMARKET(EXTREMELY)OVERVALUED?

I takeitasaxiomatic that thecontrarian trader wants toavoid being caught in the

stock market debacles of thesortthatfollowedthebubblesof the 1920s and the 1990s.These were two of the threedistinct instances of extremestock market overvaluationduring the past 100 years.The associated stock markettops occurred in 1929, 1966,and 2000. Notice that thesemarket tops were separatedby 37 and 34 years, almostoneandahalfgenerations in

each case. This sort ofextreme overvaluation doesnot occur very frequently,perhapsonceoratmosttwiceinthelifetimeofacontrariantrader.Inthesethreecasesthesubsequent drop in theinflation-adjusted Dow JonesIndustrial Average amountedto87percenttothe1932low,62 percent to the 1974 low,and 42 percent to the 2002low. The 2007 high in the

Dowwas substantially aboveits2000peakbutaccordingtomy analysis (see chapters 14and 15) was not associatedwith a stock market bubble.Nonetheless, from its 2007hightoits2008lowtheDowdropped an inflation-adjusted51 percent. Being able tosidestep declines of thismagnitudeshouldbeagoalofevery contrarian trader. Buthowmight thisbedone?Are

thereanycommonfeaturesinthe price fluctuationspreceding these importantstock market tops that mighthave warned of grossovervaluation?

Here is the way I try toanswer this sort of question.Eachofthefirstthreemarkettopsendedabullmarket thathad not been interrupted byanydeclineofasmuchas30percent in nominal terms or

by any decline that lasted asmuch as eight months fromhigh to low. These were thebullmarketsof1921-1929,of1949-1966, and of 1987-2000. In inflation-adjustedterms, prices advanced 496percent,334percent,and346percent respectively duringthese bull markets. Theseadvanceslasted8,17,and13years respectively.Moreover,only the first of these three

bull markets began from theprecedingcrashlow.Thestartofthe1949-1966bullmarketoccurred after 17 years hadelapsed from the 1932 low,while the 1987-2000 bullmarket started 13 years afterthe1974low.

Let’s see if we cancombinetheseobservationstomake some rough-and-readyguesses about the top of thenext bubble. One possibility

is that the low we are nowseeing develop in 2008 willbe historically analogous to1921. I think it far morelikely that the 2008 lowwillplay this role than will the2002 low.Why? As we willsee later, the bearish crowdsof 2008 are very powerful,indeed much more well-developed than were thebearish crowds of 2002. Idon’t think we would see

such strong bearishinformationcascadesoccurinthe midst of a bull marketleading to a bubble top. Solet’s suppose that 2008 isanalogous to 1921. In thiscasewewouldexpectatoptodeveloparound2016afteranadvance of at least 250percentinrealtermsfromthe2008low,whichIwilltakeas7,552 in theDowIndustrials.Assuming inflation of 3

percent per year for the nexteight years, the bubble topwould occur near 33,000 intheDowaround2016.

WhydidIuse250percentinsteadof the largernumbersassociated with the threepreviousbubblebullmarkets?I wanted to be conservative,yetstayinthesameballpark.Halfofthebiggestadvanceis248 percent, and this is nottoo much less that the other

two.But feel free todoyourownguesstimating!

Why 2016? Well, theobviousansweristhatif2008is like 1921, then since the1921-1929bullmarket lastedeight years this one should,too. But actually I would bevery surprised if the nextbubble top occurred so soonafter the 2000 top. I think itmore likely that if a bubblebull market is actually

starting in 2008, then it willprobablylastbetween13and17 years, putting the topsometime during the years2021 to2025.Thiswouldbelong enough after the 2000top for a new generation ofinvestors to grow up andmakethesamemistakestheirparents and grandparentsmadeduringthebubbleofthe1990s.

If2008isnotthestartofa

bubble bull market, then thetopofthenextbubblewillbepushedoutfurtherintimeandmuch higher in price. Thenext bubble bull marketwouldthenhavetostartsomenumber of years after 2008andfromaprice levelhigherthan the2008 low.Onceyouthink you have seen thestarting point of the bubblebullmarket, you can use theprecedents cited earlier to

guesstimate the level andtimingofitsultimatetop.

Ihavejustillustratedhowacontrarian trader can identifysituations of extremeovervaluation in the stockmarket.Butsuchbubble topsare infrequent events. Thereare many less dramatic bullmarket tops occurring in theintervals between majorbubble tops. These lessdramaticbullmarkettopsare

seenonaverageeveryfourorfive years. Can themethod Ihave just illustrated beadaptedsoastohelpidentifythese situations of lessextreme overvaluation? Ibelieveitcan.Infact,I’lltellyouabouttwosimplerulesofthumb I use to do this. Butfirst a warning: I think onlyan expert, experiencedcontrarian trader shouldattempt to identify these less

extreme periods ofovervaluation. For thereasons I cited earlier, thecosts of making a mistake—of anticipating a top whennone occurs—can be verysubstantial. I don’t think theeffort is worthwhile for anewcomer to contrariantrading.

That being said, here aremy two rules of thumb foridentifying moderate periods

of overvaluation. First, atypicalbullmarketintheU.S.stock market averages about24months from low to high.Second,a typicalbullmarketcarries the averages upwardabout65percentfromlowtohigh. These are two usefulfacts, but of course the realdifficulty lies is determiningwhether any particular bullmarket will be typical. I’mafraidIwillhavetoleavethis

as the subject of anotherbook.

WHENISTHESTOCKMARKETUNDERVALUED?

I think that the typicalcontrarian trader would dowell to specialize in

identifying and exploitingperiods of marketundervaluation. Periods ofundervaluation tend to be ofmuch shorter duration thanperiods of overvaluation.Moreover, bearish marketcrowdstendtobemorevocal,emotional, shorter lived, andeasier to identify that bullishcrowds.Finally,therelentlessupward path of economicprogress in free market

economies stacks thedeck infavor of trying to exploitundervalued situations. Thesecular upward trend worksto mitigate any mistakes thecontrariantradermaymakeinhis effort to identify periodsof undervaluation and theassociatedbearishcrowds.

How frequently do thestock market averages in theUnited States becomeundervalued? The answer

depends on just how big avaluation mistake we aretalkingabout.

The really bigundervaluation mistakes inthe U.S. stock marketsoccurred in1932and1982. Isaythisbecausethe1932lowassociated with the GreatDepression ended a drop instock prices of 85 percent inreal terms from the 1929high. The 1982 low ended a

drop of about 74 percent inreal terms from the 1966high. You might wonderabout the value of Tobin’s qratio at these lows (seeChapter5 foradiscussionofTobin’s q ratio). At both oftheselowstheqratiowas0.5or below and thus indicatedthat the stockmarketwas 50percent undervalued relativeto the replacement value ofthe real assets owned by the

companies in the marketaverage.

Waseitherthe2002loworthe 2008 low a comparablevaluation mistake? I don’tthink so, and here are myreasons.First, thedropintheinflation-adjusted Dow wasjust42percentfromthe2000highand51percent fromthe2007high.Thesenumbersarerelatively high in a historicalcontext, but neither is high

enough in my judgment tomakethemcomparabletothe1932 and 1982 situations.Second,atthe2002lowtheqratiowas1.5andat the2008lowtheqratiostoodnear1.0.Neitherreadingiscomparableto the levels of 0.5 seen in1932and1982. (SeeChapter16 for more discussion ofstockmarketvaluationsatthe2008 low.) I think thecombination of these two

facts means that at the 2002and 2008 lows, the stockmarket was not nearly asundervaluedasithadbeenatthe1932and1982lows.

Wesee then thatvaluationmistakes of the 1932 and1982 varietymay occur onlyonce every 50 years, so thenextonemaynotbedueuntil2032. Obviously, thecontrarian trader has to lookfor less extreme examples of

undervaluation.

For more than 100 yearsthe U.S. stock market hasestablished bear market lowpoints on average every fouryears, with perhaps 70percent of these successivelowpointsbeingseparatedbyan interval of three to fiveyears. Thus during a typicalinvestinglifetimeof40yearsan individual would onaverage encounter about 10

of these opportunities. I liketo think of bear markets asfalling into three categories.A short bear market wouldtypically drop the stockmarket averages 20 to 25percentandlastabouteightornine months from high tolow. A normal bear marketwould drop the averagesabout 35 percent and lastabout18monthsfromhightolow.Anextendedbearmarket

would drop the averagesabout45percentormoreandlast 30 months from high tolow.

Extended bearmarkets arerare. The 2000-2002 drop inprices was an extended bearmarket lasting 31 to 33months, depending on whichaverage you use as ayardstick. The Dow dropped39 percent (no inflationadjustment) during that time,

while the S&P 500 dropped50 percent. The bear marketthatbeganin1937didn’tenduntil 1942, a span of 61months during which theDowdropped52percent.Thepreceding extended bearmarket was the 1929-1932event,duringwhich theDowfell 89 percent in nominaltermsina34-monthperiod.

Normal bearmarketswerealso rather unusual events

during the twentieth century.The 1981-1982 drop in theDow lasted 16 months butcarried the average downonly 25 percent. The 1976-1978bearmarketdroppedtheDow 28 percent over an 18-monthperiod.The1973-1974bearmarketdroppedtheDow46 percent over a 21-monthperiod. The 1968-1970 bearmarketsawtheDowdrop36percent over 17 months.

Notice that all of these bearmarkets occurred during theadjustment period in whichthestockmarketmovedfroman extremely overvaluedcondition in 1966 to anextremelyundervaluedonein1982.

The most common bearmarket—and the one I thinkcontrarian traders shouldbecome skilled in exploiting—is the short bear market

that lasts about eight or ninemonths and drops pricesabout20to25percent.Shortbull markets are aphenomenon associated withextended stock marketadvances, such as those of1921-1929, 1942-1966, and1982-2000. I’ll have a lotmore to say about how theseshort bull markets can beexploited when I describe“The Grand Strategy of

Contrarian Trading” inChapter 11. Here let me citesome typical instances ofshortbearmarkets.

There was an unusuallybrief bear market associatedwith the Long Term CapitalManagement crisis of 1998.Then the Dow dropped 22percentinbarelytwomonths.Another unusually brief bearmarket was associated withpreparationsforthefirstGulf

Warof1991.Fromahigh inJuly 1990, the Dow dropped23percentinabouttwoandahalf months. A thirdunusually brief bear marketoccurred in 1987 for noobvious reason. Then theDow dropped 37 percent inthreeandahalfmonths,withmostofthedeclineoccurringon a single day, October 19,1987.

Notice that these were

three consecutive short bearmarkets, and each was ofvery subnormal durationcompared with the eight- tonine-month average for thespecies. Perhaps this was acluethatabubblebullmarketwas under way during 1987-2000. A similar situationdeveloped during the bubblebull market of 1921-1929,which was interrupted bysubnormal bear markets in

1923 and 1926. This mayprove to be a clue that abubble bull market is underway the next time we seesuchaphenomenondevelop.

Short bear markets wereprevalent during the 1942-1966 stock market advance.Therewasashortbearmarketin 1946, which dropped theDow 25 percent in fivemonths. Another occurred in1956-1957. It lasted 18

months (with 99 percent ofthe decline occurring duringthe final three months) anddropped theDow20percent.The short bear market of1960 dropped the Dow 18percentinninemonths,whiletheshortbearmarketof1962dropped that average 29percent in six months.Finally, the 1966 short bearmarketcarriedtheDowdown27percentineightmonths.

Whatdothesestatisticstellus? Every time the stockmarket averages drop 20 to25 percent from a high andthree to five years haveelapsed since the precedingbear market low point, wemust suspect that the markethas entered a zone ofundervaluation. This is thetime to look closely forevidence that a bearishmarket crowd has become

mature and is about to beginits process of disintegration.I’ll have much more to sayabout how to do this insubsequentchapters.

THEPEAKOILBUBBLE

Just so you won’t think thatthe tabulationmethod I have

illustrated for the stockmarket averages can’t beappliedelsewhere,let’stakealookatacompletelydifferentmarket, that for crude oil. InJuly 2008 crude oil sold at$147 per barrel. (This isbeing written in August2008.) I think a very matureinvestment crowd has grownaround the themeofpeakoiland is about to start itsprocess of disintegration.

Recall that believers in thepeak oil theme assert thatworldwide production ofcrudeoilsoonwilloralreadyhas reached the highest levelit will ever attain, andsupplies of petroleum willsoon start contracting. Theimplication is that crude oilpriceshavenowheretogobutup.

Let’s takea lookatwhatatabulation of the historical

dataonoilpricescan tellus.Before the first Arab oilembargo in 1973, crude soldfor$2.35perbarrel.By1981it had risen to a high of $39before declining. In 1998 itreached a low price of $11and,asmentioned,ittradedat$147inJuly2008.Hereistheway I look at this pricehistory.

Ineightyearsfrom1973to1981 crude oil rose 710

percent in inflation-adjustedterms.From1981to1998,anintervalof17years,itfell84percent in inflation-adjustedterms.In10yearsfrom1998to 2008 crude oil advanced910 percent in inflation-adjusted terms.Note that theduration of this 910 percentadvanceexceeds thedurationof the1973-1981advancebyonlytwoyears.Theinflation-adjusted price rises are

comparable also:910percentversus 710 percent. This is agood reason to think oilwasveryovervaluedat$147,and,as I have mentioned, a veryvocal, bullish investmentcrowdhasformedaroundthepeakoiltheme.

Theprognosisisthatcrudeoilisabouttobeginadropinits inflation-adjusted pricethat may well last 17 years.The 1981-1998 drop carried

thepricedown84percent. Ifinflation averages 3 percentover the next 17 years, thenan inflation-adjusted drop of84 percent from the $147level would put the price ofcrude at $38 in 2025.Remember that all of thesenumbers are adjusted for anexpected level of inflationthat Ihaveguessedwillbe3percent per year for the next17 years. You will have to

update this guesswith actualinflation numbers to getupdated versions of thesepriceprojections.

CHAPTER7

HowCrowdsCommunicate

The informationconveyed byinformation cascades• two types of

information • beliefsand stories that makeup the investmenttheme•theroleofthemedia • theconfirming action ofmarketprices •1994-2000 bubble as anexample • the potentbrew of emotionalpersuasion • the roleof the mass media •telling people what

they want to hear •media amplification •monitor the mediamidwives • whatmediasourcestouse•printmedia • Internetmedia • blogs •television and talkradio • flipping andthe real estate bubble• Jay Leno •tomorrow’s mediawill be different from

today’s • be flexibleandalerttochanges •monitoring themarkets•datasourcesI use • here, too,things will change •thevalueofhistoricalaccounts

WHATDOINFORMATION

CASCADESTELLINVESTORS?

In the first part of this bookwe developed a theory ofinvestment crowds.Investment crowds areresponsible for the manymistakes markets make.Crowds are an inevitablefeature of our socialenvironment. They arise

naturally from our desire toform social bonds and makeuse of the information aboutour world that is transmittedviathesehumanconnections.

Torecognizeaninvestmentcrowd,onehas tounderstandthe communication processesthat enable the investmentcrowdtoformandthenatureof the information theseprocessesconvey.Rememberthat an investment crowd

arises from an informationcascade. We want to learnhowtorecognizeacascadeinactionandtoidentifythesortof information it conveys. Ifwe can do this, we have agoodchanceofbeingable toidentify an ongoing cascadeand to watch the associatedcrowd as it grows andeventually forces a marketmistake.

The information

transmitted inacascade isoftwo types. First are thespecific beliefs and factsconveyed by the foundingmembers of the crowd topotential newmembers. Thisis the stuff of the crowd’sinvestment theme. It is alogically coherent story butone intended to trigger anemotional response ratherthan scientific agreement.Typically, this first sort of

information is transmittedthrough the electronic andprintmedia,althoughperson-to-person contact often playsa role as well. Thistransmission mechanism isopen to public view. Thetransparent nature of themedia gives us theopportunity to watch theinformation cascade developsimply by keeping track ofthe number and intensity of

themessages.

However, information thatmerely elaborates on aninvestment theme would notbyitselfbepersuasivewereitnotaccompaniedbyasecond,more dramatic piece ofpersuasion: a big change inthe market price in thedirection predicted by thetheme that has enriched asmall but visible group ofinvestors(ormadethemalot

poorer!). Indeed, it is theprospectofgettingrichorthefear of getting poor thatcreates the emotional powerthe investment theme needsto attract a crowd ofinvestors.

Toillustratethislastpoint,let’s recall the dot-combubble of 1994-2000. Doesanyone imagine thatinvestment themes like thenew economy and the

transforming power of theInternet would have beentaken seriously if the stocksof America Online (AOL),Yahoo!, and other dot-comshadn’t firststaged impressiveadvances, if a steady streamof initial public offeringshadn’t made their luckybuyersrich?No,Idon’tthinkso, either.Butonce investorssaw how much money theymight have made had they

picked up these themes earlyenough, they were hooked.The logic of the investmenttheme was simply icing onthe cake, a convenientjustification for joining thecrowd.

Weseethenthateconomicandbusiness informationandforecasts, the dreams andfears of investors, and themovements of prices in thefinancial markets all have

important roles toplay in thecreation of an investmentcrowd.Theyall arepartof apotent brew of persuasionthat manifests itself in aninformation cascade. But adramatic change in the priceof some asset always comesfirst.Thisistheprimemoverand seed of the informationcascade that will ultimatelycreate an investment crowd.Onlyafterthefactistheprice

change ever explained byappeal to economic andbusiness developments. Eventhen, these explanations areonly dry, unemotional facts.By themselves they will notpersuade an individual whohas no time or skill forscientificanalysis.Todotheirwork, these explanations areleavened with emotionalappeals togreed, to fear, andtothenaturalhumandesireto

get ahead of one’s fellows.Then and only then will theinformation cascade gathermomentum and create a newinvestmentcrowd.

THEROLEOFTHEMASSMEDIA

There would be noinvestment crowds in the

modern world without theprint and electronic media.Indeed there is a fascinatingsymbiotic relationshipbetween the media andinvestment crowds. Whenpeople get rich or poorbecauseofabigchangeintheprice of some asset orcommodity,themediahaveastoryto tellandonetheycansell. Remember that themedia business is all about

tellingpeoplewhattheywanttohearsothatadvertiserswillbewilling topay to reachanattentive audience. Storieslike this attract readers andthus advertisers. But then aninteresting thing happens.Becausethemediabusinessisvery competitive, the samestory is picked up by othermediaoutletsandinthiswayspreads far and wide. Thesehuman stories of success or

failure become widelyknown. Success breedsimitators while failuresencourage others to sharetheir stories of distress. Thisprocessinturngeneratesevenmorestoriesofthesamesort,and thesestories in their turnencourage more imitators.The entire process amplifiesthe effects of the originalstory. What begins as awhisper, barely audible even

to the careful listener,eventually becomes acacophonyofcommunicationamong the media and itsnewborn offspring, theinvestmentcrowd.

This is indeed a fortunatesituation for the contrariantrader. Because the print andelectronic media aremidwives to the birth ofinvestment crowds, we havethe opportunity to watch

crowdsdevelopfromtoddlersto mature adults just bymonitoring media content.The particularmethods I usetointerpretthesignificanceofthis content will be thesubjects of subsequentchapters. For now I want todiscuss the media sources Imonitor to help me identifyinformation cascades inoperation.

AsIwritethisin2008,the

printmedia are still themostimportant lines ofcommunication for theinformation cascades thatbuild investment crowds. Icheck the New York Timesand the Chicago Tribuneeverymorning for interestingstories about the economy,finance, and business. Frontpage stories are especiallynoteworthy. Any majormetropolitan newspaper can

be used in the same way. Infact,ifyoureadalocal,smallmarket paper you willoccasionally find stories onthese topics thathaveamorepersonal,localflavorandthatcanbejustassignificantasasimilar one in a majornewspaper.

Afterdailynewspapers,thenextmostimportantmeansofmonitoring informationcascades are weekly and

monthly newsmagazines.Thoseofgeneral interest likeTime and Newsweek are themostimportantonestowatch,becausetheygenerallydonotdevote much space toeconomic and businesssubjects. When they do,especiallyifthestoryappearson the cover, you have asignificant and unusualsituation,whichtellsyouthatthe associated investment

crowd is probably a veryimportantandsubstantialone.

Other general interest andpoliticallyorientedmagazinescanalsobeused in thisway.Over the years I have usedstories from U.S. News &World Report, the NewYorker,New York magazine,the New Republic, andHarper’s (to name just afew). Any magazine ofsignificant circulation can be

usedforthispurpose.Infact,for this reason I periodicallyvisit my local big-boxbookstore(inmycaseBarnes& Noble) because it has alarge magazine section. Icheckoutthecoverstoriesforall the magazines displayed,even the ones I don’tnormally read. I do thiswhenever I think aninformation cascade hasreached critical mass. It is

amazing how easily cascadescan be identified using justthissimpledevice.

So far I have left outbusiness-oriented magazineslikeFortune,BusinessWeek ,andtheEconomist.Thesecanbe very valuable, too,especiallywhenacoverstoryisdevoted toa recentmarketevent. But youmust keep inmind that these sourcesgenerally have many cover

stories devoted to theeconomy and business, sosuch covers don’t carry thesameweightandsignificanceas do the covers of Time orNewsweek.

YouhavenodoubtnoticedthatIhavelefttheWallStreetJournal off my list of printmedia sources. There is agood reason for this. TheWSJ’s primary focus is onbusiness and finance.

Consequentlyit isdifficult toidentify the importance of astory from its positioning onthe newspaper’s front page.The only WSJ stories I payattention to are thosedescribing in some detail theworkings of an investmentcrowd that I have alreadyidentifiedfromothersources.I use the WSJ as acorroborating source, not aprimaryone.

Over the past 10 years, animportant competitor to theprintmedia has arisen. I callthese the Internet mediabecause they are deliveredprimarily through the Webbrowser you use to accessonline resources. Every oneof the print media nowadayshas an electronic edition thatcan be accessed over theInternet. The Web contentpublished by the print media

changes from hour to hourand fromday to day, so it ismore difficult to track andrecord. The same is true ofcontent that appears on siteslike MarketWatch orBloomberg. The basic thingto keep in mind is that thechangeability of this contentmakes it relevant to veryshort-term (days, not weeks)crowdbehaviorandthusisoflimited use for gauging

information cascades.However,onecangetasenseof what these sites regard asnewsover periodsofmonthsjustbypayingdailyattentionto them. For example, stockmarket industry groups comeintoandfalloutof favorandsoarementionedmoreorlessfrequently over a period ofmonths. The same is true ofindividual stocks orcommodities. Remember that

the Internet media want tokeep people’s interest andtherefore highlight storiesthey think will interest thebiggestsegmentofthepublic.So their editorial choices tellyou something about theireditors’ perceptions of themarkets that hold the mostinterestfortheirreaders.

I also follow many blogsdevoted to investing, finance,andeconomics.Iwon’tname

them here, simply becausemy list changes frequently—the lifetime of a typical blogis only a couple of years (oreven less). However, generalinterestblogslikeInstapunditaswellasblogswithastrongpoliticalpointofviewcanbeveryuseful reading.You canbesure thatanyeconomicorfinancial market that attractsintense public interest willfind mention on these blogs,

together with links to otherrelevant Internet material.Keeping up with the contentofadiversifiedlistofblogsisan essential activity for thecontrariantrader.

There are other electronicmedia that are important butnotdistributedontheInternet(at least not yet). These arenetworkandcable television,talk radio, and the movies.Here, too, the basic rule that

the media are profit-seekingentities that have to cater topeople’s interests andprejudices serves thecontrarian trader well.Generally, programmingspecials can tell you a lotaboutwhatpeoplehopefororfear. Even more significantarenewTVseriesthatappearjustasanassociatedcrowdisabout to begin itsdisintegration process. The

most recent example of thissort occurred in 2005-2006with the appearance ofseveral cable shows devotedtohouseflipping(i.e.,buyingahouse,fixingitup,andthenselling it for a profit, allwithin a couple of months).The first episodes of theseshows marked almost theexact top of the real estatemarket and preceded thesubprime market debacle of

2007-2008. As I write this(July 2008), a new realityseries has appeared on cableTV. It’s called Black Goldand depicts the day-to-dayactivities of the roughneckswhomantheoilrigsonthreeseparate West Texas drillingprojects.Forfuturereference,notethatthepriceofcrudeoiliscurrently$143perbarrel.

AnotherillustrationofhowTV shows can give useful

information to the contrariantrader occurred in July 2002,just as the S&P 500 indexwas approaching its bearmarket low at 768 (its lowthatmonthwas 771). I am afanof theTonightShowwithJayLeno.Forthefirsttimeinmy memory Leno startedtelling jokes about the stockmarket crash and theeconomic recession (whichhad in fact ended in late

2001) inhismonologues thatmonth. At the time I foundthis strong corroboratingevidencethatthebearmarketcrowd of 2002 was about todisintegrateandthatthestockmarket’slowwasathand.

AWORDABOUTPERSONAL

FLEXIBILITYAND

THEFUTUREOFMEDIA

I am writing this chapter inJuly2008,butIhopethatthisbook will be of interest tofuture generations ofinvestors as well. Thephenomenon of investmentcrowdsisatimelessone.Onecanexpectthenatureofmassmedia and their means of

delivery to evolve inunpredictable and surprisingways over the years ahead. Idon’t doubt that my futurereaders will find thepreceding discussionantiquated in its specificdetails.

However, the generalprinciples by which oneidentifies informationcascades are timeless. Toapply them, one needs to

monitor thespecific formsofmasscommunicationofone’sera. The forms andtechnology used by mediawill evolve, so a contrariantrader must be constantlyinvolved in a media watchandbeflexibleandwillingtoadjust his procedures asneeded. Some media willgrow in popularity, whereasothers will decline. It is thecontrariantrader’sjobtokeep

abreast of this evolutionaryprocess, of the constantlychanging nature ofmodes ofmass communication. It willbethecontentofthesemediathat enables the contrariantrader to identify ideas andthemesthatdriveinformationcascades.

MONITORINGTHE

MARKETS

Whilethemassmediaplayanessential role in helping thecontrarian trader identifyinformation cascades and theinvestment crowds theycreate,thesemediaarenottheonly grist the trader can orshoulduseinhistradingmill.Acontrariantradermusthaveextensive knowledge of the

historical behavior offinancialmarkets.Hemustbeable toput themarketsbeingpushedbyinvestmentcrowdsinto a quantitative context.Ideally,hewantstobeabletoestimatehowbigamistakeamarketmaybemakingandtoget some sense of when orwhether the associatedinvestment crowd is stillgrowingstrongerorisinsteadonitslastlegs.

This is not easy to do foreven the most skilledcontrarian trader. But it isimpossible to do at allwithouta substantialbodyofhistorical market data. Insubsequent chapters I’lldiscussspecificwaysofusingthishistoricaldatatomonitorthe status of an investmentcrowd. In this chapter Iwantto confine my attention tosources of data and to the

kind of data one wants tomonitoranduse.

At the moment the singlemost useful source forhistoricalstockmarketdataisthe freeYahoo!Financewebsite, from which one candownloaddata inspreadsheetformat.Astheyearspassthissource will grow in value.But remember that theInternet and informationstorage technologies are

evolvingrapidly.So10yearsfrom now the situation maychange and Yahoo! may nolongerbeagooddatasource.It is the jobof the contrariantrader to stay abreast ofinformational resources sothatwhenheneedshistoricalinformation he knows wheretolook.

Another good source ofhistorical information inchart-based format currently

is theonlineChartStorewebsite. For an annualsubscriptionfeeonecanviewhistorical charts of stockmarket averages, interestrates, foreign markets,currencies,andcommodities.

A third source for chart-basedstockmarketdatathatIuse at the present time isStockCharts.com, anothersubscription-based web site;ithasavastnumberofcharts

kept up to date in varioususer-controlledformats.

The only thing I am sureabout is that 10 years fromnowIwillprobablybeusingdifferent sources for myhistorical market data than Iusenow.Thefinancialworldis constantly evolving andwith it the nature of theinformation resources onemust use to keep abreast ofevents. It is the job of a

contrarian trader to knowwhere he can obtain relevantinformationevenastheworldchangesaroundhim.

STUDYINGTHEHISTORYOFBUBBLESAND

CRASHES

There is another source ofinformation that can help thecontrariantraderplacecurrentinformation cascades andinvestment crowds in theirproper historical context.These are the historicalaccounts of past marketbubbles and crashes. Thesehistorical accounts can beentertaining, but they alwaysprovide food for thought andopportunities for critical

analysis as well. Later inChapter 16 I shall suggest anumber of books that I havefound useful and interestingfor this purpose. No doubtmany more will appear astimepasses.Historyisalwaysbeing written and oftenrevised in the light of newinformation.

WhenIgotmystart in thestock market in 1965 thegreat crash of 1929 had

occurred 36 years earlier. Itseemed tome then asdistantas the time of the RomanEmpire. I like to think thateven as a novice I wasinfluencedbytheexperiencesof other speculators, which Ihad learned about fromreading historical marketaccounts. As I write thesewords, the market events oftheintervening43yearshavealso been recorded for

posteritybymanyauthors.Totoday’s novice contrariantrader these events no doubtseem to be ancient history,too. But my personalexperience as a marketparticipantduringthepast43yearsinformseverythingIdoas a contrarian trader. It isessential for every contrariantrader to build his techniqueupon a body of experience,evenifatthebeginningofhis

career it is only secondhand.The only access the novicehastotheexperienceofthesemarket events is throughthese historical accounts.Makeuseofthem.

CHAPTER8

ConstructingYourMediaDiary

Skill of a contrariantrader • fromdeduction to action •media diary aids

analysis andstrengthens trader’sbelief in hisdeductions•atradingtool and a trainingtool • your diary willbe your anchor towindward • how mydiary made adifference in2002 •awonderful learningtool • put your diaryin a notebook • cut

and paste • whatmedia content isrelevant • excerptsfrommydiaryin2005• excerpts from mydiary in 2006 •magazine covers •examplesfrom2006

GAININGTHEEDGE

A contrarian trader’s edgearises from two unusualskills. The first is his abilityto consistently identifyinvestment crowds and theirinvestment themes. Thesecond is his capacity formaking rational deductionsfrom these observations andtranslating these deductionsinto buying or selling for hisportfolio in themarkets. It isrelatively easy to acquire the

firstskill.Butitisthesecondthat is themore difficult andyet themore essential one. Itis his ability to translateobservation and knowledgeinto profitable investmentactions that distinguishes thecontrarian trader from therun-of-the-mill devil’sadvocateornaysayer.

Yourmediadiaryplaysanessential role in helping youdevelop both these skills. It

will be a contrarian tradingtool as well as a contrariantraining tool. It will containall the material you need toidentify investment crowds,their investment themes, andthe emotional state of thecrowd. More important, bystudying your diary in thelight of subsequent marketaction, you will gainconfidenceinyourdeductionsand will strengthen your

ability to act contrary to thetheme of the crowd at therighttime.Yourdiarywillbeyour anchor to windward onthe sea of finance against itsconstant turbulence of boomandbust.

Let me remind you againthatitisvery,very,veryhardto be a contrarian trader. Ifyou are to succeed, you willneed the help of a well-maintained, up-to-date media

diary. It will help you resistthe siren songs of themedia,whicharetheprincipalmeansof communication forinvestment crowds. It willteach you to float above thepanic that develops duringplunging markets and theeuphoriaduringsoaringones.It will help you to shrug offthe scorn and derision ofcrowdmemberswhodiscoveryou are betting against them.

The rest of the world willthinkyouareatbestrashandatworst stupid; andon thoseoccasions when your tradesdon’t work out, the “I toldyou so’s” will be deafeningandvery hard to endure.Butyourmediadiarywillbethereto offer objective evidencethat you made the reasonedchoice despite anyunfavorable result. Theemotional world of any

contrarian trader is aturbulent one, and emotionalturbulence is the enemy ofclearthinking.Itwillbeyourmediadiarythatwillhelpyouto navigate these turbulentemotional waterssuccessfully.

Howwillyourmediadiarydoallthis?Howwillitenableyou to acquire the emotionalbalance needed for the high-wire performance of

contrarian trading? Theanswer is surprising simple:Your media diary willobjectify the emotionalcontent of media messagesand market movements byfreezingthemintime.Inthisway they can be reexaminedwhen the immediateemotional stresses of themoment have passed. Bydoingthisyouwillbeabletosee clearly the correlations

between the content of themedia when a crowd isenthusiastic and subsequentmarket performance. Thesehistorical observations basedon firsthand, real-timerecording of media contentwill develop your ability toidentify the emotionalextremes of crowd behaviorand strengthen yourwillingnesstoinvestoppositethe crowd’s theme at such

times. The media contentpreserved in your diary willhelp you remember how youfelt at the time. Only bylearninghowthemediamakeyou feel when a contrarianinvestment opportunity is athand can you learn to actcontrary to the mediamessagesthaturgethecrowdonward to its doom anddisintegration.

Yourmediadiarywillplay

anotheressentialroleaswell.It will be your principal toolfor identifying investmentthemes and the associatedinvestment crowds. Yourmedia diary will record themedia messages that play acentral role in motivatinginvestment crowds. Thesemessages are the principalmeans of communicationamong investment crowdmembers. Media content is

the driving engine ofinformation cascades. Bystudying this content andcomparing it to analogoushistorical situations, youwillbe able to assess just wherean investment crowd standsin its life cycle. Thesedeductions in turn will helpyou implement “The GrandStrategy of ContrarianTrading”(seeChapter11).

I have kept a media diary

formorethan20years.Ithasproved itself invaluable foridentifying investmentcrowds.Ithastimeandagainhelped me select the rightmoment to take a contrarianstance in the market. It hastaughtmetohaveconfidencein my own judgment and toresist the seductive call ofinvestment crowds.Mydiaryis my single most importantcontrariantool.Ifyouwantto

become a contrarian trader,you must start your mediadiary now. In this chapter Iexplain how I maintain mymedia diary and whatmaterial goes into it. This isthemostimportantchapterofthisbook.

HOWMYDIARYMADEA

DIFFERENCEIN2002

Beforewegetintothedetailsofbuildingandmaintainingamedia diary, I’d like to tellyou a true story thatunderlinesthevalueofsuchadiary, even for a novicetrader.Thisstoryshowswhata valuable educational toolyourmediadiarycanbe.

Back in March 2000 thestockmarkethadreached thepeak of the 1994-2000bubble. The S&P 500 tradedas high as 1,553 andeventuallydroppedalmost50percent to a low at 768 inOctober 2002. The home ofthe dot-com andtelecommunication stocks,the NASDAQ Compositeindex, reached a high of5,132 in March 2000 and

droppedalmost80percent toa low of 1,108 in October2002.

In January 2000 it wasobvious to me and to manyothers that a stock marketbubblehadinflated.Theonlyquestion was how big amistake the market wouldmake before the bubblepopped.Thisisjustaboutthehardest judgment anycontrariantraderhastomake.

If you get it wrong, thedamagetoyournetworthcanbe serious. I knew that thetypical bull market in thestock market averages lastsabout two years. Thepreceding bear market lowhadoccurredinOctober1998with the S&P at 923.Combining these two facts, Iguessed that the bubblewould continue to inflateuntilroughlyOctober2000.

Over a three-week periodfrom March 24 to April 17,2000,theS&Pdroppedabout14 percent, from 1,553 to1,333. The NASDAQComposite dropped astomach-churning 25 percentduring the same threeweeks.Since I expected the markettomoveabovethe1,553levellater in the year, this seemedto me an opportunity to putcash reserves to work with

the prospect of earning 15percent over the subsequentsixmonths.

My media diaryemphasized this opportunity,too. On Saturday, April 15,the New York Times ran itspage 1 headline: “StockMarket in Steep Drop asWorried Investors Flee;NasdaqHasItsWorstWeek.”Thesamedayourlocalpaper,theMorristownDailyRecord,

headlined: “Wall StreetWreck.” I should say thatboth averages reached theirlow points early Mondaymorning, April 17, andcontinued upward for fourand a halfmonths. The S&Pdidnotmakeanewhighbutdid rally to 1,530 byAugust31.AweeklaterIwastellingmy clients to sell inanticipation of a drop below1,300.

Anyhow,althoughIamtheinvestment strategist in ourfamily, I always consult mywife before we change theallocation in our retirementportfolios. In this particularinstance we were havingdinnerwithourthreechildrenat a local pizza place onFriday,April14.OverpizzaIsuggested to her that we putcash to work in the stockmarket because the severe

drop of the past three weekshad presented an unusualopportunity.Butshefeltveryuncomfortable about doingthis,citingtheseverityofthedrop; she suggested a wait-and-see stance instead. Iknew that this wastantamount to passing up theopportunity entirely, but forvariousreasonsIchosenottoarguetheissue.

Afewweekslatermywife

andIwerediscussingthislostopportunity. She explainedthat theheadlines at the timewere very scary andmade ithard to act, so I took herdown to my office andshowed her my media diary.We looked at the twoheadlines citedearlier,whichI had clipped out and pastedinto my diary. Then Ireviewed with her theprevious five or six buying

opportunities in the stockmarket and showed her theheadlines and other mediacontent that appeared as thebuying opportunitiespresented themselves. Ofcourse ineverycase the timeto buy was when theheadlineswerescariest.

Fast-forward to late July2002. The S&P 500 indexhadthatmonthdroppedtoitslowestlevelinmorethanfour

years. Alan Greenspan,chairman of the FederalReserve, blamed a corporateculture blighted by“infectious greed” for thebreakdown in investorconfidence. On NBC’sTonight Show Jay Lenoregaled his audience withjokes about crashing stockprices and a swooningeconomy.

The July 29 issue ofTime

magazine had a cover storyasking: “Will You Ever BeAbletoRetire?—WithStocksPlummetingandCorporationsin Disarray, Americans’Financial Futures Are inPeril.” (Emphasis is in theoriginal.)

For the previous week’sissue of Barron’s Ben Steinand Phil Demuth wrote anarticleentitled“ALongWayDown.” They predicted that

stock prices still had a longwaytofallbecausecorporateearningsstatementscouldnotbebelieved.

OnJuly20Iwasupat6:30in the morning and openedour front door to retrieve theSaturday editions of theNewYork Times and theChicagoTribune. I was spreading thenewspapers out on ourbreakfasttablewhenmywifewalked into our kitchen.We

sat down together, me withmy coffee and her with abowl of Special K. I like tostartwiththeNewYorkTimesbut she prefers to read theChicagoTribunefirst.

Here was the New YorkTimes headline thatmorning:“Market Continues Four-Month Rout; Dow Plunges390.”TheheadlineofastorybyFloydNorris rightnext tothisheadlineread:“Addingto

Loss of Investments, a LossofFaith.”

“Yikes!” I thought. Mywife read the Tribuneheadline to me: “Dow DivestoaFour-YearLow.Sell-OffDeepens: People Are ReallyFeelingPainNow.”

We were both silent for aminute or so. She wasobviously digesting theheadlines and I wondered

how shewould react. Finallyshelookedacrossthetableatmeandsaid,“Iguessit’stimetobuy?”

“Yes,”Ireplied.

OnMondaymorning, July22,weboughtindexfundsforour retirement accounts withthe Dow at 8,019 and theS&P 500 at 846. During thesubsequent five years theseaverages advancedmore that

75percentfromourpurchaseprice.

Here was a situation inwhichacompletenovicewasable to make a very shrewdinvestmentdecision.Mywifehadobservedfirsthand inmymedia diary the correlationbetween scary marketheadlines and buyingopportunities. From this shewasabletodrawtheobviousand correct conclusion.

Without a media diary thatfaithfully captured theemotional state of the crowdand preserved it for futureexamination, this sort oflearning experience wouldnothavebeenpossible.

GETREADYTOCUTANDPASTE

Tostartyourmediadiary,thefirst thing to do is buy somefive-subject spiral notebooksplus some manila folders touse for keeping files ofmultipage stories andmagazine covers. You willalso need a good pair ofscissors and lots of Scotchtape. Take one of thenotebooks and put a title onthefrontcover;IliketowriteDiary together with the date

of the first entry. When thenotebookhasbeenfilledup,Iadd thedate of the last entryto thecover and thenput theentire notebook on mybookshelfforfuturereferencealongside my older diarynotebooks.

Whatsortofmediacontentdeserves to be preserved inyour media diary? Theanswer to this question issimple, but perhaps a little

surprising. Remember thatmarket movements alwaysgenerate news stories thatencourage the belief thatprices will continue to movein the samedirection.Peoplewant explanations formarketevents, and this demand forexplanation is something thenews media strive to satisfy.Therefore, you want to lookfor stories reinforcing theoptimistic or pessimistic

moods that arise from risingor falling asset prices. Theseare the stories that willreinforce the beliefs of theinvestment crowds you haveidentified. The mostimportant of these are theones that directly conveysome obvious emotion (i.e.,pushtheemotionalbuttonsofsome investment crowd).Such stories might promotefear or optimism; it doesn’t

matterwhich.These displaysofemotiongenerallyshowupin emotionally tinged wordsor expressions, ordescriptions of investorbehavior. Pictures often canbe used as emotionalmessengers,sodon’tforgettowatchforthem,too.

We’ll see that whenenoughsuchstoriesappearina relatively short interval oftime, especially if they are

likely to trigger emotionalresponses from investors, thetrend that the story seems toencourage will insteadprobably reverse. You willprincipally be interested inmedia content likely to catchthe attention of the casualreader, people who, likeyourself,arepressedfor timeand can’t examine stories inany detail. It is the casualreader who is most likely to

be affected by the emotionaltone of media content.Moreover, it is the casualreader whom news editorswant toattract toboostsales.The things that attract theattentionofcasualreadersareheadlines, story headers, andmagazinecovers.WhenIfinda story that has such aheadline or header, I mightread the first two or threeparagraphstotrytogaugeits

emotional tone, but rarelywillIreadmorethanthat.

Be especially alert forstories that editors think areimportantenough toputonanewspaper’s front page orthatareotherwisehighlightedby theirposition in thepaperorbytheemotionalcontentoftheir header or of a pictureappearingwiththestory.Asageneral rule, a prominentplacement on the front page

signals two things: First, theeditorsthinktheirreaderswillfind the story of greatinterest, and this gives you areadonjustwheretheeditorsthink thecrowd’sattention iscurrently focused. Second,the prominent placementattracts the attention ofmorepeople, and thus is a morepowerfulreinforcementofthecrowd’s mood and beliefs.Here I should add that the

editorial page can also be avery good source ofmaterialfor your media diary. Mostnewspapers rarely commenton market movements ineditorials, so when they doyoucanbeprettysurethataninvestment crowd is on theverge of disintegration. Thearticles that appear on op-edpagescanalsobevaluableinthisregard.

You will want to be as

systematic as possible inchecking for market-relatedstories in all the sources Icitedintheprecedingchapter.Hereismyowndailyroutineforsurveyingmediacontent.

I start each morning bytakingalookattheNewYorkTimes and the ChicagoTribune over breakfast. I amprincipally interested instories that appear on thefront page of either

newspaper, but sometimesthere will be a story on thefront page of the businesssectionorevenastoryinsidethe paper somewhere thatattracts my interest. When Ifindsuchastory,Imakesureto tear out those pages andadd them to my stack ofarticlestopasteintomyspiralnotebook.

I’ll clip any story that islikely to catch the casual

reader’s attention because ofitsheadlineorheader,orevenbecause of a picture thatappears alongwith the story.Thestory’ssubject isusuallysomeaspect of the economy,business, or the behavior ofthe stock, bond, orcommodity markets. Butsometimes you will find astory that focuses on aninvestment crowd you haveidentified, explains its

motivations, and gives anindication of its emotionalstate.Iputthissortofstoryinmy diary, too. I want toemphasize once more thatthat you are looking formedia content that tends toreinforce the beliefs of theinvestment crowds you arefollowing.Yourgoal is tobeabletoefficientlyseparatethecontent that will play animportant role in reflecting

andreinforcingcrowdbeliefsfrom the content that is justpart of the daily and weeklymedia noise the financialmarketsgenerate.

I’d be less than honest atthis point if I didn’t tell youthat experience with keepinga media diary matters here.Astimepassesandyourdiarylengthens,youwillgetbetteratselectingthestoriesthatarereally helpful for assessing

the state of an investmentcrowd and at ignoring theonesthatareofonlymarginaluse. Knowing just whichstories are important partlycomes from firsthandknowledgeofwhatgoesoninmarkets on a day-by-daybasis. It also arises frommyknowledge of where marketpricesstandrelativetorecentand historical ranges andextremes.Thisskillhastaken

many years to develop butproves invaluable time andagain. You can develop it,too, with practice. (That iswhy you should start yourmediadiarynow.)

When I first startedkeeping a media diary, Itended to clip far too manystories. I thought that thediarywouldpermitsomesortof statistical analysis ofmediacontent.Isoonlearned

that this was not onlyimpracticalbutwrongheaded.Themedia diary’s real valuelies in the experience ofreading theheadlinesand thearticles in your diary againstthe backdrop of marketbehavior at the time. Bydoing thisyouget a senseofthe mood of the crowd thatyoucanget innootherway.More important, you acquirea feel for the intensity of an

investment crowd’semotional reaction to marketand economic events. Thisintensityoffeelingandbeliefis something only my mediadiarycanconveytome.Itcanbe judged in no other way.This is one reason thatstatistical, survey-basedapproaches to contrariantrading tend to have littlevalue. They don’t give youthe ability to assess the

intensity of an investmentcrowd’s beliefs, fears, andhopes.

OnceIhaveclippedwhatIneed from the dailynewspapers,Igodowntomyofficeandcheckanumberofnewsweb sites togetherwithseveralmarket-orientedandafew general-interest blogs. Idon’toftenputmaterial fromthese sources in my mediadiary. Only once or twice a

week on average do I find astory or opinion piece that Ifeel gives useful informationabout one of the investmentcrowds I am tracking.Recently I have started tosavescreenshotsofheadlinesof web sites (likeMarketWatch) that aredevoted solely to financialmarkets. I am sure that astime passes and electronicsources become increasingly

important parts of the mediaindustryI’lldevotemoretimeto capturing and recordingtheir messages to investmentcrowds,too.

Once I’ve checked myInternet sources, I glance atthemagazines thatmay havearrived in the mail. I don’tsubscribe to every magazinethat might have usefulcontent. Instead I check eachmagazine’s web site for the

latest issue. It isusuallyeasyto see just by looking at itscover whether there is anycontent related to investmentcrowdsinthemagazine.

When I find a cover storythat is market related, I tearoff the cover and staple it tothe inside pages of theassociated story. If I don’talready subscribe to themagazine,Itrytobuyacopyfrom my local bookstore. If

this isn’t possible, I return tothe magazine’s web site andprint out a copy of the storyalong with an image of anyassociated cover. Thesemagazine stories I file in afolderlabeled“coverstories.”I have another foldercontaining stories ofcontrarian interest that aren’tcoverstoriesandaretoolongto put inmy spiral notebookmediadiary.

EXCERPTSFROMMYMEDIADIARY:NOVEMBER2005

I’d like to give you a moredetailed illustration of whatmy diary actually looks likeso that you can get a bettersenseofthekindsofstoriesitcontains. My object now isnot to explain in any detail

howthediarycanhelpyoutomake investment decisions.Insteadmyimmediategoalisto give examples of stories Iseeasimportant,examplesofmaterialsIliketopreserveinmy diary, and examples ofthe sort of marketconsequences thisinformation can lead you toanticipate.

I have just pulled downfrom my shelf of media

diaries the one containingcontent that appearedbetween October 25, 2005,and September 18, 2007, aperiod of about 23 months.Generally I find thatanywhere from 18 to 30monthsofmaterialwillfillupa single five-subject spiralnotebook.Exactlyhowmanymonthsofmaterialitwilltakedepends on the nature of themarkets at the time. Quiet

markets generate less mediacommentary than do volatileones or ones setting recordsofonesortoranother.

Thefirstentryinthisdiarywas a story that appeared onNovember 4 in the businesssection of the New YorkTimes (henceforthabbreviated NYT). It washeaded “Bears Have TheirDay” and discussed the factthat 2005 had been a good

year for hedge fundsspecializinginshortselling.Iclipped this article because Iknewthatwhenevertheshortsellers are prominent in thenewspaper it is time to buystocks. This was noexception.TheS&P500rosefrom about 1,220 when thisstoryappearedtoabout1,450on the last day recorded inthisdiary.

The next clipping was a

Wall Street Journal story onNovember8headed“ForeignStocks Get New Push.” Thestory tells of Wall Streetfirms raising their allocationlevels to foreign stocks torecord levels. Foreign stocksmake money for investorsprimarily when the dollarfalls, so I interpreted thisstoryasabetagainstthethenrising trend of the dollar. Itwasdefinitelynotastorythat

reinforcedthebullishtrendinthedollaratthetime.Infact,aboutamonthlaterthedollarstarted a 30-month, 24percent drop and thus madethese Wall Street firms looklike geniuses. I should saythatIdidnotseethisbigdropin the dollar coming, largelybecause of stories like thisone that did not indicate thepresence yet of a significantbullishdollarcrowd.

TheNovember14 issueofNewsweek provided my nextdiary entry. It was Robert J.Samuelson’s column entitled“Worry While You Spend,”which had a great interlinearsubhead: “What explains thegap between Americans’glum mood and their free-spending ways?” I clippedthis story because itreinforced my view that nobullish stock market crowd

had developed despite athree-yearrallyfromthe2002low, which had alreadycarriedtheS&P500from768to 1,220. I found thisremarkable, but I shouldemphasizethattheabsenceofa crowd tells you nothing inand of itself aboutprospective market direction.(See the previous paragraphabout thedollar foremphasisofthisfact.)

Mynext entrywas a storydated November 4 thatappearedontheMarketWatchweb site. Note that it waspasted into my diary out ofproper chronologicalsequence. This sort of thinghappens,especiallywithWebor magazine content, and Idon’t worry too much aboutit.ButIamcarefulalwaystonote the source of everyclipping and the date of its

appearance.

This MarketWatch storywas a column by MarkHulbert, who edits theHulbert Financial Digest, anewsletter that tracks therecommendations andmarketperformance of financialnewsletters. I have foundHulbert’s columns veryinformative at times becausehehimselfisadevoteeofthecontrarian art. Moreover, he

has at his disposal hard dataabout opinions,whichwouldbe very difficult for anyindividualtoduplicate.Inthisparticular column Hulberttells the reader that the bondmarket timing newsletters hetracks at the HulbertFinancial Digest have as agroup never been morebearish on bond prices. Heoffers statistical evidence toback up this observation. I

shouldnote that according tomy records the bond marketmade a low point onNovember 4 and then ralliedfor two consecutive months.However,aftertherallybondprices eventually droppedbelowtheirNovember4 low.Nonetheless, Hulbert’scontrarian warning was avery valuable piece ofinformation for a contrariantrader, and the subsequent

market rally was normal forthe kind of evidence thatHulbert offered in hiscolumn.

AlongthesamelineswasaWall Street Journal storydated November 17, whichwaspastedintomydiaryjustafter the Hulbert column. Itwas headed “A Message intheBondMarket.” Itwarnedthattheyieldcurvewasaboutto invert and said this was

bearish for bond marketinvestors. The storyreinforced my view at thetime that bond prices wouldrally at least for a couple ofmonths.

The next story pasted intomydiarywas abrief columnthat appeared in the businesssection of the New YorkTimesandwasheaded“RapidRise: Google Passes $400 aShare.” I saved this not

because I thought it hadimmediate marketsignificance but because Iwanted to keep the story ofthe Google crowd current inmy diary. I had beenfollowing it for 15 months,ever since Google’s initialpublic offering (IPO) at $85per share in August 2004.The reason for my earlyinterest was a very unusualcircumstancesurroundingthis

IPO. At the time, theinvestment crowd focusedonGooglewasabearishone,notthe bullish crowd onenormallyexpectstoseeatthetime of an IPO. This was sounusual that I noted it andbrought it to the attention ofmy clients. I begancommentingonGoogleintheweblogIstartedin2005(youcan find it by googling myname). My basic theme was

thatuntilthebearishcrowdinGoogle morphed into abullish one, Google’s stockpricewouldprobably rise farmore than anyone expected.In April 2005with the stocktradingat$224Iciteda$500target, but this proved to beway too conservative. ByNovember 2007 Google hadreached$747.

TheNovember28issuesofBusinessWeek and Fortune

gave me my next two diaryentries. The BusinessWeekstorywasheaded“ThisSpreeCouldSpuraStockSurge.”Itdescribed how the boom inprivate equity purchases ofpubliccompanieswasaddingfuel to the stock marketadvancefromits2002lows.Ibelievedthistobeanaccurateassessment of one of thereasonsforthebullmarketinstocks, and I clipped the

article because I wanted tokeep tracking this story untilits end—which probablywould be associated with animportantstockmarkettop(itwas, in 2007). The Fortunestorywas of a different sort.Itwasentitled“InvestorsAreIn foraShock”andsubtitled“Financial assets are richlypriced.” The article isaccompanied by a cartoon ofan investor who has climbed

a staircase but, like Wile E.Coyote, has continued pastthe end of the staircase andnowhoversinmidair(priortoa crash). I love to pastestories that are accompaniedby interesting photographs,cartoons, or charts into mydiary.Theyalwayshavemoreemotional intensity thanmedia content without anyparticularvisualinterest.Thisparticular story asserted that

thereturnsonfinancialassetsarelikelytobefarworsethanpeople expect. I shouldpointout that the bull market instockshadtwomoreyears torun at the time this storyappeared. I clipped thecolumn as evidence that abullish stock market crowdhadnotyetformed.

EXCERPTSFROM

MYMEDIADIARY:JUNE2006

Iputonlyeightstories inmydiary during the month ofNovember 2005. It was aslowmonth but an otherwisetypicalone.Themarketsweregenerally stable or rising atthe time. You will find thatmost months won’t providediary material dramatic

enough to call for anyinvestment actions. Just theopposite is true for monthsassociated with stock marketdrops. The pages of mymedia diary fill rapidly atsuch times. One of thesemonthswasJune2006.

OnMay5, 2006, theS&P500 index closed at 1,325. Itfell therestof themonthandreached a low close of 1,223on June 13. This was a

relatively quick 8 percentdrop in prices, normal for abullmarket.FromtheJune13lowtheindexwouldrallytoahigh close of 1,575 inOctober 2007, an advance of29 percent. Here is what Irecorded in my media diaryduringJune2006.

ThefirststoryofthemonthwasanothercolumnbyMarkHulbert. It had nothing to dowiththestockmarket.Instead

Hulbert’s focuswas on gold,which had reached a high of$725earlyinMayalongwiththe stock market and hadsincedroppedabout$100perounce. I should note that theactual low of this dropoccurred on June 14 withgold selling at about $550.Hulbert noted in this columnthat gold timing newslettershadbylateMaymovedfroma very bullish stance to a

position of being on averagecompletely out of the goldmarket. He interpreted thisbullishly. As I have said, Ilike to keep a record ofHulbert’s views because hetriestotakeacontrarianviewof the markets and oftenoffers useful facts to backthemup.

ThenextdiaryentrywasacolumnbyDanielGrossfromtheNewYorkTimesbusiness

section of June 4. In it henoted the strongperformanceof the U.S. economy duringthe first quarter of 2006 andcontrasted this withconsumers’ ratherpessimisticexpectations of the future. Ithought this was significant,again because it suggestedthere was no importantbullish crowd then active inthestockmarket.

On June 6 theWall Street

Journalheadlineditspersonalsection with a story headed“Cash Becomes a HotInvestment.” The story saidthat stock market volatilityand rising interest rateswereprompting investors to shiftintomoneymarketfundsandcertificates of deposit (CDs).I interpreted this as a bullishomen for both the stock andbondmarkets. I have alreadyexplained what followed for

theS&P500index.Thebondmarket rallied for sixmonthsfromitsJune2006lows.

That same day I clipped aWall Street Journal story byE. S. Browning that washeaded “DowFalls 1.77%asFed Chief Adds to InvestorJitters.” This meritedinclusioninmydiarybecauseoftheuseoftheword jitters,an indicator that fears werebuilding among stockmarket

investors.

NextamongtheJune2006diaryentriesweretwoout-of-sequence entries of contentfrom the Internet. BothappearedonJune5.Thefirstwas a MarketWatch columnby Peter Brimelow, whichreported the gold bug HarrySchultz’sprediction thatgoldwas headed for $3,000 perounce.Theseconditemwasacolumn by Michael Barone,

political commentator. Iunderlinedthemostimportantsentence of his piece: “YetAmericans are in a sourmood, a mood that may beexplained by the lack of asense of history.” Thisclipping was only a smallcontribution to the story of ageneral disconnect betweenactual economic conditionsandAmericans’ views of thefuture. I didn’t see this as a

situation encouraging thedevelopment of a bullishstockmarketcrowd.

“Foreign Markets ExtendDecline as Rate Fears CurbRisk Appetite” was theheadline of a front page,below-the-fold story in theWallStreetJournalonJune9that I clipped for my diary.The phrase rate fears I felthad bullish implications forthe stock market and for

interest rates.Myattention isattracted to stories thatcontain phrases indicatingstrongemotionsofonesortoranother.

FromtheJune12editionofBarron’sIclippedpartofthe“Up and DownWall Street”column,whichthatweekwaswrittenbyMichaelSantoli.Init he made two observationsthat put him in both bullishshort-term(right)andbearish

long-term (wrong) camps. Iunderlined in red thesesentences:

[A]nxiety levels,measured bothstatistically andanecdotally, seem tohave risen more thanthe 5% to 6%declinefrom recent stock-index highs wouldwarrant.

andthen:

[T]here’s anemerging sense offorebodingauguringaless-generous[market]environment.

On June 13 I clipped anitemfromBillCara’sblog.Itshowed a picture of a blackbearandwasaccompaniedbythiscomment:

As traders are now

glued to their screensin hopes of seeingsome evidence thattodayand tomorrow’sU.S. inflation datawill permit the fundsrate to fall, this is thepicture they aregetting.

The Wall Street JournalhadafrontpagestoryonJune14, thedayafter thelowwasmade in theS&P500,which

was headed: “TumblingMarkets May Be Reflectionof Strong Growth—InvestorsStruggle to Adapt to Demiseof Easy Money; Dow GivesUp 2006 Gains.” That samedaytheWallStreetJournal’smarkets section washeadlined: “Interest-RateFears Drive World-WideSlide.”ThenextdaytheNewYork Times had a front pagestory,placedrightnexttothe

headline story, which washeaded:“AModestRiseStillAmplifies Inflation Fears—Lessons of 70’s PromptStrongWarnings.”

On June 16, on its frontpage, the New York Timespublished a line chart of theDow Jones IndustrialAverage recording the dropfrom its May 10 top. Thecaption of the graph said:“Relief, at Least for Now.”

But in the textof thecaptionone finds: “But the increasedvolatility in the marketssuggested that their troublesmaynotbeover.”Thegraphwas interesting not justbecause of this text butbecauseitshowedapictureofa market in the process ofdropping. Images like thisoneareverygoodreflectionsofemotional statesand servealso to amplify these

emotions,inthiscasefear.

The Chicago Tribune ofJune 16 was headlined, inreference to Ben Bernanke,chairman of the FederalReserve: “When Big BenSpeaks . . . the MarketReacts.” The headline wasaccompanied by an intradaychart of the Dow for theprevious day, which showedthe start of a rally whenBernanke started to deliver a

speechinChicago.

At this point you haveprobably noticed that thefrequency of stories that Ibelieved pushed emotionalbuttons increased around thetime of the market low onJune13.Thisistypicalofthemediacontentassociatedwithlow points in the stockmarket. The stronger thedisplay of emotion via storyfrequency and intensity, the

more important and long-lastingwillbethelow.Highs,by contrast, tend to occuragainst a more diffusebackground, sometimesaccompanied by an absenceof strong emotion of anykind.WediscussthisinmoredetailinChapter9.

The June 19 issue ofBarron’s was interesting forseveral reasons. First, theinveterate stock market bear,

Alan Abelson, noted in hiscolumn that the latestInvestors Intelligence surveyof market letters showedmore bearish sentiment thanat any time since the bearmarket lowofOctober 2002.He observed that this meantthat some sort of bounce(rally) was inevitable. Butthenhewentontodisputethelonger-term implications ofthesenumbers:“[W]esuspect

thattheglimpseofrealitythatunhinged the markets willbecome the increasinglyprevailingviewinthemonthsahead.” In other words,Abelson dismissed thelonger-term significance ofthe large bearish contingentinthesurvey,arguinginsteadthat, aside from a short-termbounce, the bears would beright this time. In myexperiencethereisnothingas

bullishasabearishviewthatexplicitly dismisses thesignificance of widespreadbearishsentiment.

In that same issue,Barron’shad twostories thatwere also relevant for thestock market. The first wasthe midyear roundtable ofmarket seers offering theirpredictions for the secondhalf of 2006. The story washeaded: “High Anxiety.”

Wow!Seldomdoesonecomeacross an emotion-ladenheadlinelikethisone.

The second story wasabouta fellownamedRobertA. Haugen. Haugen’s thesiswas that increasing stockmarket volatility wasinevitable and would set thestagefordepressionorworse.Herecommendedshuttingthestock market for two days aweek to calm things down.

ThisBarron’sstoryillustratesa general principle.Journalists may not revealtheir biases to you directly,but they often will do soindirectly though theirchoiceof story material. Moreover,this very choice of subjectmatter reveals theirperception of readers’interestsandconcerns.InthisinstancethechoiceofHaugenas the subject for this story

was essentially an attempt toappeal to the current fearsofBarron’s readersand toofferan implicitbearishpredictionofthefuture.

The June 18 Sundayedition of the New YorkTimeshadacolumnbyMarkHulbert in which he alsocatered to the then-currentbearish sentiment. In its firstparagraph he says: “Badnews, stock investors: the

market is likely tounderperform garden-varietymoneymarket funds throughtheendofnextyear.”

There are a handful ofother stories I put into mydiary later that month, butthey all reinforce the theme,which I think you can seeclearlybynow.Asthemarketreached its June 13 low in2006,more andmore storiesappearedencouragingreaders

to thinkpriceswouldgo stilllower.

This example alsoillustratesanimportantmediadiary principle: Look formedia messages that tend toreinforcetheviewthatrecentmarket movements willcontinue. These are themessages that fuelinformationcascadesandthatwill enable you to assess thestrength of investment

crowds.

INTERPRETINGMAGAZINECOVERS

An important part of mymedia diary is my collectionof magazine covers. I keepthese in chronological order

inseparatefilefolderslabeledby year of appearance. Idescribed the magazines Imonitor regularly in theprevious chapter, but anyweekly ormonthlymagazinecan be the source of a coverthat speaks to an investmentcrowd.

I first learned the value ofusing magazine covers incontrarian trading from PaulMacrae Montgomery. In the

early 1970s Paul observedthatwhenTimemagazinehada cover story about aprominent businesspersonality, about the stockmarket, or about some otherfinance-related matter, onecould often infer that animportant move in themarkets was imminent, amovethatwaslikelytobeinthedirectionoppositetowhatthe cover suggested.

Optimistic covers led tounexpected drops in prices,while pessimistic covers hadtheoppositeeffect.

The theory behind thisphenomenon is a simpleone.If a business- or stockmarket-related storymakes itontoaTimecover,thismeansthat it has alreadycaught thepopular imagination and isthe theme of a largeinvestment crowd. This is

true precisely because Timecovers rarely concernbusiness topics. When theydo they must reflect opinionthathasbeenacceptedbythegeneral population ofinvestors. In suchcircumstances the investmentcrowd has little capacity forgrowth, and the time for itsdisintegration is probably athand.

InthenextchapterI’llhave

more to say about generalguidelinesforusingmagazinecover stories to identifyinvestment crowds. For nowI’d just like to explain a fewcriteria you can use todetermine whether a coverstory is important enough toputintoyourdiary.

First, you want the coverstory to focus on a specificfinancialmarketoraspecificstock. This is important

because investment crowdsorganize themselves aroundspecific markets. The coveritselfmighthighlightapersonwho is closely associatedwith themarket, for examplethe company’s CEO or thechairman of the FederalReserve. You want to lookfor covers offering implicitpredictions for the directionof the market or someemotional response to the

market’s recent behavior, themoredefinitivethebetter.

Covers that talk about thecondition of the wholeeconomy generally do notgiveusefulinformationaboutinvestment crowds. I savethese sorts of covers asindicators of general moodbut don’t use them to assessthe status of investmentcrowds. In contrast, coversthat speak of the levels of

interest rates or inflation canbe useful in identifying bondmarketinvestmentcrowds.

Themostimportantfeatureofanimportantcoverstoryisits emotional content. Themorethecoverappealstofearor to greed, the stronger itsimplication for the imminentdemise of an investmentcrowd. To illustrate how Iselect covers for my mediadiary, let’s look at the cover

stories I saved from the year2006.

The first cover story wasfrom Time magazine’sJanuary 30 issue. The covershowed Bill Ford of FordMotor Company and asked:“WouldYouBuyaNewCarfrom This Man?” The covercaption suggested Ford hadbig ideas for saving hiscompany and the autoindustry. The significance of

this cover story was hard tojudge. It appeared after a 50percent drop in the price ofFord stock from $16 to $8overtheprecedingtwoyears.One would expect such acover to express bearishsentiments. But instead itseemed to offer hope toinvestorsthattheworstmightbepast.Oneshouldnotethatthe price of Ford stock wasessentially unchanged during

thesubsequenttwoyears.

The next cover story ofinterest also concerned theautoindustryandappearedinFortune’s February 20 issue.Unlikethewarmred,yellow,andgreen colors of theTimecover, this cover appearedwith a depressing blackbackground with a blue GMlogo. The coverwas headed:“The Tragedy of GeneralMotors.” The cover caption

read: “It is the instinctivewish of most businesspeoplethat General Motors not gobankrupt.... And yet theevidence points, withincreasing certitude, tobankruptcy.” GM stock haddroppedfrom$45to$17overthe preceding two years, amuch bigger percentage dropthan Ford’s. Moreover, thisGMcoverwasstarklybearishin tone. As such, it was a

strongindicationthatthebearcrowd had grown large andcomplacent about GM. Theprice of GM went from $17to$42overthesubsequent20months.

The February 12 cover ofBarron’s featured Google’slogo Photo-shopped to read“Gurgle.” The logo wasshown sinking beneath thewater in a washbasin or tub,the implication being that

Google was going down thedrain. At the time, Google’sstockhaddropped about 100points from its early 2006highof$475andwoulddropa bit further to aMarch lowof $331. But over thesubsequent 20 months theprice of Google’s stockwould advance from $331 to$747.

Itisinterestingtonotethata week later Time magazine

also had a Google coverstory.Thisstorywasheaded:“Can We Trust Google withOurSecrets?”Thismagazinecover toldme littleabout theGoogle bullish investmentcrowd. It was not veryspecificanddidn’t implyanyparticular direction forGoogle’s stock, even thoughit did have some emotionalcontent, as revealed by theuseofthewordtrust.

The next cover of interestto me during 2006 was thecover of Barron’s May 1issue. It depicted a bullreclining comfortably againsttwo pillowswith a big smileon his face. The story washeaded: “Dow 12,000.” TheDow Jones IndustrialAverage reached a high at11,700 just a week later andthen dropped sharply to10,700 during the market

break, which ended in June2006. This story was anunusual example of a bullishcover that precisely timed ascary short-term drop in thestockmarket.

The May 27-June 2 issueof the Economist showed abrown bear on its hind legspeeking out from behind atree. It was headed: “WhichWay Is Wall Street?” Thiswas a specific prediction of

decliningstockprices.Abullor a bear that appears on amagazine cover after themarkethasrisenordroppedasubstantial amount is usuallya sign that the pricemovementisabouttoreverse.ThelowintheS&Poccurredat 1,223 on June 13, and theaverage reached the 1,575level16monthslater.

I remember beingparticularly impressed by the

cover story of theNew YorkTimes Magazine’s June 11issue. It showed a blackbackground against which ahairy, giant “debt monster”was pursuing little peoplewhowere running from it inblind terror. The covercaption was classic:“America’s ScariestAddiction Is Getting EvenScarier.” The color schemeand the double use of the

adjectives scariest andscarier showed strongemotionalcontent.Appearingas it did after a monthlongdrop in the stock market, itstrengthened and amplifiedthe emotions of the bearishcrowd that had developed bythen.

Nextwecometotwocoverstories that illustrate that onecannot blindly take a marketposition opposite to that

impliedbyamagazinecover.These storiesappeared in theJuly 24 and November 6issues ofBarron’s. The July24coversaid“TimetoBuy,”and this advice was right onthe mark. The November 6cover was headed: “NextStop 13,000?” Theappearance of the questionmark weakened thesignificanceof this story,butnonetheless theDowmade it

up to the 13,700 level thefollowing year before anysubstantialreactionsetin.

The important thing tokeep in mind about coverstories is that they aresignificant only if they arespecific in their implicationsand if they reinforce thebelief that current markettrendswillcontinue.

CHAPTER9

ImportantInvestmentThemes

Investment themes •long-lived versusshort-lived themes •firstthemarketmoves

• then comes therationale • categoriesof themes • new erathemes • things arealways different thistime • theabandonment oftraditional valuationstandards • war andpolitical crises •bearish crowds arecommon•warcrowdsform and disintegrate

quickly•intheUnitedStates buy theoutbreakofshooting•sell peace • financialcrises•generallyverybrief • most intensebearish crowd formsjust before resolution•thesubprimecrisis•individual companiesand industries •Google • commoditybooms • oil at $147

and gold at $1,000 •interest rates and thebond market •predicting a 25-yeardrop in interest ratesin 1982 • using yourmedia diary to trackinvestmentthemes

TELLINGTHEMARKET’SSTORY

Your media diary containsneed-to-know informationabout developing investmentthemes. Remember thatinvestment crowds developaround investment themes.An investment theme is arationaleformarketbehavior.It tells the market’s story byexplaining why prices havechanged so dramatically andby offering, at leastimplicitly, a prediction for

their direction in theimmediate future. Theexplanatory nature of aninvestment theme isimportant here. It is thisapparently logicalexplanation of the past thatsustains the associatedinformation cascade. This isthe identifyingfeatureofanyinvestment theme aroundwhich an investment crowdwilldevelop.

In Chapter 5 I discussedsome of the investmentthemes that were associatedwith the stockmarketbubbleof 1994-2000 and with thesubsequent bear market of2001-2002. These were veryimportant investment themes—theassociatedcrowdswerebig and long-lived. Thebubble crowds’ life cycleseach extended over severalyears, while the bear market

crowd’s life span was about24 months. But investmentthemes and their crowds canbeshort-livedaswell.Thisisespecially true of thebearishly themed stockmarket crowds. On average,bearish crowds disintegratesooner than bullish crowds.Moreover, one often finds avery short-lived bearishcrowddevelopinginresponsetosomeexternalevent,which

is blamed for a relativelybriefdropintheaverages,sayone lasting a few weeks andamounting to 5 percent or alittle more. In Chapter 8 wesaw an example of such acrowd forming during June2006. At that time theexternal event was a rise ininterest rates, which wasblamed for generating fearsthat the Federal Reservewould pursue a tighter

monetarypolicy.

When you use your diarymaterial to identify aninvestment theme, keep inmind the basic sequence ofevents accompanying thedevelopment of anyinvestment crowd. Firstcomes a dramatic rise or fallin the market averages or inthe price of an individualstockor industrygroup.Thisgenerates media content,

whichnotesthispricechangeand offers an explanation forit. These media explanationswill increase in number,frequency, and emotionalintensity as long as theassociated price trendcontinues. This is theevidence you look for to tellyou that an informationcascade is under way. Yourjobasacontrariantraderistoassess the current strength of

the crowd and to useavailablehistoricalprecedentsto make an educated guessabout where the crowd is initslifecycle.

Inprinciple, an investmentthememay tell any plausiblestory or even offer acompletelynovel explanationforachangeinmarketprices.Even so, I have found thatmost investment themes fallinto a small number of

categories.It’susefultoknowwhatthesecategoriesareandto be familiarwith a numberof historical examples ofeach.Backgroundknowledgelike this makes real-timeidentification of investmentthemesaneasiertask.

NEWERAS

Every generation or so, thestock market in the UnitedStates experiences amultiyear advance in pricesthat multiplies the marketaverages several timesand isnot interrupted by anysignificant, sustaineddownward move. Theseadvances enrich the typicalinvestor and alwaysencouragethedevelopmentofone or more bullish

investment crowds. Theclassic examples are the1921-1929 bull market,during which the Dow JonesIndustrialAverage rose from60to380,andthe1994-2000bullmarket,duringwhichthesame average advanced from3,800 to 11,750. An equallydramatic example is the1949-1966 bull market,during which the Dow rosefrom169to1,000.

As these sustainedadvances in stock pricesproceed, one invariably findsa particular kind ofinvestmentthemeemerging,atheme I like to call the “newera”theme.Peoplenoticethatstock prices have beenadvancing steadily and havealready risen higher thannormal ina typicaleconomicexpansion. Investors want toknowwhy this is happening.

Themediaarehappytomeetthisdemandforanswers.Theusualexplanationisthatthereare new industries ortechnological or financialinnovations that are drivingthe economy to previouslyunseen heights of prosperity.Inthe1920stheboomwasinradio (the new technology ofthat decade) and theautomobile industry.Installment credit was the

financial innovation of thetime, and it multiplied thepurchasingpoweroftheera’sconsumers. The new era ofthe1960swasassociatedwiththe computer, electronic, andairline industries. Theprincipal financial innovationof the time was amacroeconomic one—Keynesian economics hadtriumphed in the economicsprofession, and many

believed that itsprescriptionshad made recessions a thingof the past. There were twootherinnovationsofnote.Thefirst was the concept of theindustrial conglomerate—amerger of firms in differentindustries, which supposedlyallowed shrewd managementto extend its reach andeffects,andwhichdiversifiedthe risks of industry-specificbusiness performance. The

second innovation was theconcept of the high-capitalization, perpetualgrowth stock, neatlyencapsulated in the NiftyFifty growth stocks, whichpredominated institutionalportfolios in the early 1970s.During the dot-com years of1994-2000 the newtechnology was the Internetand the personal computer.When the globalization of

markets (which newcommunications technologypermitted) was added to thestew,theneweconomythememadeitsappearance.

Thekey identifyingphraseofnewerathinkingis“thingsare different this time.” Stayalert for this sortofassertionwhenyouarecullingmaterialfor your media diary. Manypeoplewillrecognizethatthestock prices are overvalued

by historical yardsticks. Butinvestors must be persuadedthat this will not lead to thetypical historicalconsequence,acrashinpricesand a return to normalvaluation levels. Otherwise,why would they continue tobuystocks?Duringaneweraboominstockprices,lookformedia content urginginvestors to abandontraditional stock market

valuation standards. Theywill invariably be told thatpaying only for earnings ordividends is the old way ofthinking,nowoutofdateandtypical of those people whojustdon’tgetthesignificanceofnew financialor industrialinnovations. The stockmarket bubble of the late1990s offered classicexamples of the “things aredifferent this time” theme. In

fact, I think this theme wascarriedtothesecondorderofsilliness. The first order ofsilliness consists in justifyingstock prices by revenuegrowthinsteadofbyearningsor dividend growth. But inthe second-order realm onelooks not to revenues but tothe share of potentialcustomers, the so-calledeyeball count to justifyextraordinarily high

valuations. Put another way,investors were assured thatalthough these new Internetretailers and informationservices lost money on eachcustomer they gained, theywould make up for this byincreasing the number ofcustomerstheyserved!

EFFECTOFWAR

ANDINTERNATIONAL

POLITICALCRISESONTHESTOCKMARKET

War or the threat of waralways energizes theinvestment community andfocuses the attention of alarge part of the general

population on mediamessages. Investmentcrowdsform quickly in suchcircumstances and oftendisintegratejustasquickly,sothecontrariantraderhastobealert for these rapid changesinbeliefsandexpectations.

Asarule,thethreatofwarand especially the start ofshooting creates buyingopportunities for investorswho live in the country

destinedtobevictorious.Theprospect of war almostalwaysencouragesthegrowthof a big bearish crowd. Thecrowd focuses on theconsequent loss of humanlife, the destruction ofeconomic infrastructure, andthe general uncertainty aboutthe outcome of war, andexpects stock prices to dropasaresult.Thethoughtofanimminent war depresses

people. But once war isdeclared, this bearish crowdbeginstodisintegrateassoonas there is reason to expectultimate victory. Theresulting rise in stock priceseventually causes thedevelopment of a bullish,victorycrowd.Theadventofpeace then usuallymarks thestart of the disintegration ofthe bullish investment crowdthat developed as victory

became more and morecertain. One sees thissequenceofeventsintheU.S.stock market time and timeagain.

The prospect of the CivilWar dropped prices 35percent on the New YorkStock Exchange from thetime Abraham Lincoln wasnominated in 1860 until theshooting started at FortSumter in April 1861. From

the Fort Sumter low pointprices then rose 300 percent,reaching their peak whenLincolnappointedUlyssesS.Grant as the commander ofallNorthernarmies inMarch1864.

The sinking of thebattleshipMaine inHavana’sharbor in February 1898triggered war fears that sentthe stock market averagesdownwardby15percentuntil

the United States declaredwar on Spain two monthslater. Prices then turnedaround and rose 27 percentuntilAugust,whenhostilitieshalted.

The start of the Europeanwar in July 1914 closed theNew York Stock Exchangebecauseitwasfearedthatthestart of shooting wouldtrigger a financial panic.When theexchangereopened

in December, pricesimmediately began toadvance and the subsequentbull market carried the DowJones Industrials from 53 to110 just after WoodrowWilson’s reelection in 1916.Here again the prospect ofentry by the United Statesinto war was a bearishdevelopment, and pricesdropped from 110 to 90 bythe time thecountrydeclared

war on April 6, 1917.However, unlike previousinstances, prices continueddownward for eight moremonths after the declarationofwartoreachalowpointatthe 65 level in December1917. From that point theDow advanced 35 percentuntil the Armistice inNovember1918.

On December 7, 1941,Japan attacked the U.S. fleet

at Pearl Harbor. The UnitedStates declaredwar on JapanonDecember8withtheDowtrading at 112. The stockmarket dropped another 18percent to 92 in April 1942,just prior to the turn towardvictory in the Pacific at thebattle of Midway in earlyJune 1942. The Dowsubsequently continuedupward to the 212 level inMay1946, ninemonths after

the surrender of Japan and afullyearafterthesurrenderofGermany.

TheKoreanWarbeganonJune 25, 1950, and the Dowdroppedfrom224to197overthe next three weeks. U.S.ground troops entered KoreaonJuly1.The197lowintheDowhasnotbeenseensince.

The Cuban missile crisisoccurred inOctober 1962. In

June of that year the Dowendeda25percentdropfroma high at 734 in December1961. The June low at 535was not broken at any timeduring themissile crisis.ThefirstinklingofSovietmissilesin Cuba reached the U.S.intelligence services inAugust1962withtheDowat620.Themarketdroppedtoalow at 549 onOctober 24 asthe crisis developed. A

peaceful resolution wasreachedonOctober28.

The Vietnam War was adifferent kind of conflictbecause it had no definitebeginning through adeclaration ofwar or start ofhostilities. However, it didhave a definite end for theUnited States with the ParisPeace Accords, which weresigned on January 27, 1973.The Dow reached a record

high close at 1,051 onJanuary 13, 1973, and overthe subsequent 23 monthsdropped nearly 50 percent toa low at 577 in December1974.

The Watergate scandalforced the resignation ofRichard M. Nixon from thepresidency of the UnitedStatesonAugust9,1974.Asnoted before, the Dowreached its low four months

later, and thatDecember lowwas at essentially the samelevel as an earlier low onOctober10.

The first Gulf War beganfor the United States inJanuary 1991. SaddamHussein’s Iraq had invadedKuwaitinearlyAugust1990.FromitsJulyhighin1990atthe 3,000 level, the Dowdropped toa lowat2,363onOctober 11, 1990. Prices

never went lower than thateven as the United Statescontinued toprepare forwar.Itwaswidelyexpectedat thetimethatthestartofshootingwouldsendpricesbelowtheirOctober low at 2,363. Iappeared on CNBC severaltimes that fall and in earlyJanuary, and asserted thecontrary view that the stockmarket was about to begin ahugerally.TheUnitedStates

commenced air operationsagainst Iraq on January 15,1991, with the Dow closingthe previous day at 2,482.Over the next six weeks theDow advanced 20 percent.The Dow has never sincebeenaslowat2,482.

The United States wasattacked by terrorists onSeptember 11, 2001. TheDow ended the previous dayat9,605andthestockmarket

was closed for several daysafter theattack, reopeningonSeptember 17. The Dowcontinueditsdrop,reachingalow at 8,235 on September21. From there the Dowrallied to 10,635 on March19,2002.

The second Gulf Warbegan with the invasion ofIraqbyU.S.forcesonMarch20, 2003. The run-up to thewar was a confusing time

politically in the UnitedStates and internationally asopposing political forcesdebated the merits anddangers of such an invasion.The Dow Industrials reacheda low at 7,425 onMarch 11,and then moved upward to14,164 on October 9, 2007.Subsequently the averagedropped 24 percent by July2008.Itwillbeinterestingtosee whether history will

record the second Gulf Waras being won during the lasthalf of 2007 following thedefeatofAl-QaedainIraq.Ifso, thiswouldbeyet anothercase in which victory or theassurance of victory markedan important top in stockprices.

This historical reviewshould convince you that thethreat and the reality of warexertastronginfluenceofthe

public’s emotions. Theemotional turbulenceassociated with warencourages the rapiddevelopment anddisintegration of investmentcrowds, and these crowdsforce markets into valuationmistakes. The frequentmarketmistakes arising fromwartimeconditionsofferveryimportantopportunitiestothecontrariantrader.

FINANCIALCRISESCREATE

CROWDS

Financial crises that attractwide public attention areusually associated with thecollapse or near collapse ofsome domestic or foreignfinancial institution or of thecredit of some sovereign

nation. Most financial crisesare of relatively shortduration, and as a rule theygenerate bearish investmentcrowds. I’d like to brieflyreview a number of suchcrises that have occurredduringthepast35years.Notehow frequently crises areassociated with stock marketbuying opportunities. Thishappens because the news ofthe crisis spreads rapidly in

the media, as does the fearsuch news generates. In amatter of days or weeks theassociated informationcascade has persuadedeveryone who can bepersuaded to join the bearishcrowd. The crisis reaches itsclimax with some sort ofgovernment intervention—aguarantee or rescue—and thebearish crowd begins todisintegrate.

Therehavebeenanumberof financial crises over thepastthirty-fiveyears.OnJune21, 1970, the Penn CentralCorporation defaulted on itscommercialpaperobligationsand declared bankruptcy.This briefly threw the U.S.commercialpapermarketintoturmoil. One should note,however, that a 17-month-long bear market in stockprices had ended just four

weeks earlier with the Dowclosing at a low of 631 onMay26. It is also interestingtonotethattheJune1editionof Time magazine featuredFederal Reserve chairmanArthurBurnsonitscoverandwas captioned: “Is ThisSlump Necessary?—Facingan Economy on the Brink.”The Dow proceeded toadvance to 1,051 on January11,1973.

The 1974 low in stockprices developed twomonthsafter the resignation ofRichard Nixon from thepresidency. This was apolitical crisis, but a weakeconomy was the subject ofTime cover stories onSeptember9andOctober14.The failure of the FranklinNational Bank occurred onOctober 8, and the lowpointof the S&P 500 index at

62.28 occurred on October10. The S&P 500 has neversincetradedaslow.

On August 12, 1982,Mexico’s finance ministerinformed the U.S. FederalReserve that Mexico woulddefault on certain short-termdebt obligations and that itsforeign exchange marketswould close the followingday.AmonthearlierthePennSquare Bank had failed in

Oklahoma. The Dow JonesIndustrial Average reached alow at 777 on August 12,1982, after dropping from ahigh at 1,024 in April 1981.The777lowkickedoffabullmarket that over the next 25years carried the Dow to14,164.

TheJuly-Octoberperiodof1998sawabriefbutsharp20percentdropintheU.S.stockmarket averages. On August

17 the Russian governmentdevalued the ruble anddefaultedondebtobligations.The resulting turmoil inworlddebtmarketsbroughtaU.S. hedge fund,LongTermCapital Management(LTCM), to the brink ofinsolvency. Judging the firmtoo big to fail, the U.S.Federal Reserve organized atakeover of the LTCMportfolio on September 23.

OneshouldnotethattheDowreached its closing low near7,530 on August 31 and itsintraday low for the year thenext day. The Dow thenadvanced to 11,750 byJanuary2000.

ThelastfinancialcrisisI’dliketoreviewisthesubprimecrisisof2008.I’llhavemoreto say about this in a laterchapter.Fornow,sufficeittosaythatthecrisiswasbornof

the worldwide housingbubble, which peaked in theUnited States in 2005. Thatspectacular advance inhousing prices was fueledpartly by easy credit andpartly by mortgage loansmade to borrowers ofsubprime quality, borrowerswho often had insufficientassets or income. This wasonly possible becausemortgage loans were

securitized, bundled togetherinto packages that were inturnslicedanddicedintonewsecurities, so-called tranches.The subprime loans werehidden fromview behind thecomplicated mathematicalformulas that determined thepayouts investors got fromeach tranche.These formulasdepended on financialvariables with which no onehadanystatisticalexperience,

so investor payouts wereimpossibletopredict.Instead,buyersofmortgagesecuritiesreliedontheratingsthatfirmslike Moody’s InvestorsService and Standard &Poor’s provided for thesebonds. Here of course wehaveacaseoftheblindbeingledbytheblind.Inanyevent,when large numbers ofsubprime borrowers began todefault on their mortgages,

thepricesoncertain tranchesof mortgage securities fellspectacularly. (In late July2008 Merrill Lyncheffectively wrote downmortgage securitieswith facevalue of $36 billion by 95percent!)Evenworse,noonein the financial communitycouldbesurewhichbanksorbrokerage firms carried suchsecurities (now known astoxic waste) on their books.

Thiseffectivelyfrozemarketsforcertainkindsofsecuritiesand loans, and the resultingconstriction of creditthreatened to plunge theUnited States and the rest ofthe world into a seriousrecessionordepression.

The stock marketconsequencesofthesubprimecrisis have not yet beencompletely recorded as Iwrite this (in November

2008). There have been atleastthreemajorgovernment-sponsoredrescuesoffinancialinstitutions so far. The firstoccurred in mid-March 2008when the brokerage firm ofBear Stearns collapsed andwas purchased by JPMorganChase. The second occurredin mid-July when mortgageintermediaries Fannie Maeand Freddie Mac wererescuedbyaFederalReserve

credit guarantee and by acongressional housing rescuepackage. The third was therescue on September 16 oftheinsurancegiant,AmericanInternational Group. But ofeven more importance wasthe government decision inmid-September to allow thebankruptcy of the LehmanBrothersinvestmentbank.

The financial crisisassociated with the panic of

2008 was a significantexception to the historicalrule that such crises tend tobe brief. Instead of lasting amatter of weeks, just a fewmonths, the panic of 2008extendedthroughmostoftheyear, and as this is beingwritteninlate2008, itshowsno signs yet of abatement.Even so, I think that historywill record that theSeptember-November 2008

period, the time when thecrisis was most intense andwhen panic was in the air,was a terrific buyingopportunity in theU.S. stockmarket.

NEWINDUSTRIESANDCOMPANIES

This category is almost self-

explanatory. Technologicalprogress and businessinnovationsareconstantfactsof life in the capitalisteconomy’s Schumpeterianworldofcreativedestruction.Newindustriesariseandnewbusiness firms emerge tobring these innovations tomarket.

Railroads were thespeculative darlings of thelate 1800s, but industrial

firms began to take the reinsfromtherailroadsintheearly1900s, a change signaled bytheformationoftheStandardOilholdingcompanyin1899and of U.S. Steel in 1903.During the subsequent twodecades the automobileindustry grew spectacularly.Led by Ford and GeneralMotors, it changed theeconomic landscape forbusiness and consumers

forever. Radio was the bigtechnological innovation ofthe 1920s and RCA was thespeculativeleaderoftheU.S.stockmarketof1929.

Fast-forwarding to the1960s, we find the computerindustry’s first incarnation inthe formof IBM, thebiggestmanufacturer of mainframecomputers at the time. Thepassenger jet led to a rise inairlinetravelduringthesame

period, and airline stockswere among the growthstocks of the time. In 1980thebirthofthebiotechnologyindustrywas heralded by theinitial public offering (IPO)of Genentech, abiotechnology firm started in1976. The biotechnologysectorisstillrapidlygrowingtoday.The1980salsosawthecomputer industry’s secondincarnationwiththeadventof

the personal computer (PC),brought tomarketbyIBMin1981. Computer softwarebecame a growth industry atthe same time whenMicrosoft captured the rightsfor producing the IBM PC’soperatingsystem.

The 1990s witnessed thepopularization of the Internetandtherapiddevelopmentoftelecommunicationstechnologyintheformofthe

mobile phone and fiber-opticcable networks. Newcompanies like AmericaOnline, Dell Computer,Lucent Technologies, andWorldCom led the stockmarket upward during thoseyears.

Oneofthemostinterestingnew companies of the firstdecade of the newmillenniumisGoogle,whosesearch engine technology

dominates the market todayandhasbeenusedasadeviceforsellingonlineadvertising.GooglehaditsIPOinAugust2004at$85.ThreeyearslaterGoogle stock had risen to$747but it thenfell toa lowof $247 during the panic of2008. An interesting thingabout Google is that therewas a very well-developedbearish crowd at the time ofits IPO. This was

unprecedented in myexperienceandletmetotakea very bullish stance onGoogle at the time. You canread the story of Google’sIPOinChapter14.

The investment themesassociated with newcompanies and emergingindustries are usually bullishthemes and project virtuallyunlimited growth ahead forthecompanyor industry.But

the contrarian trader shouldbe careful about being tooskeptical about such themeswhen he first sees thememerge. The fact is that in abig, ever more globaleconomyanynewtechnologyor innovation has a lot ofpotential for growth. Ofcourse no tree grows to thesky, but as we will see insubsequent chapters, thecontrariantraderisoftenwise

to join the bullish crowds ofthese individual companiesand industries temporarily.The trick is to stay alert forthe spread of the bullishcontagion to less attractiveand compelling relatedsituations. Once late-comingcompetitors arrive on thescene, it is usually time forthe contrarian trader to leavethe bullish crowd andconsider taking a different

investment position oppositethecrowd’stheme.

COMMODITYBOOMS

Every so often the price ofsomeindustrialoragriculturalcommodity risesdramatically, sometimes tonew historical highs, in

response to some change indemandorsupplyconditions.Occasionally severalcommodities do thissimultaneously—a situationthat often is associated witheconomy-wide inflation. Bigmoves in commodity pricesoftenspilloverintothestocksof companies associated inone way or another with thecommodity.Thesecompaniesmay be producers, providers

of services or equipment toproducers,banks that financeproducers,andsoon.

The1972-1974period sawadramaticriseinagriculturalprices for wheat, corn,soybeans, and relatedproducts.Goldwentfrom$35perounceto$200bytheendof1974.InOctober1973thefirst Arab oil embargooccurred, and by 1974 theprice of crude oil had

increased fourfold to$13perbarrel. A second though lesspronounced advance incommodity prices occurredduring 1979-1980 and wasassociatedwiththesecondoilcrisis, which saw the per-barrel price of crude oil risefrom $13 to $39. The year1980 also saw a peak U.S.inflation rate of 13 percent,the highest level of thepreceding 30 years and a

level not seen since.Accompanying this generalinflation was an upwardmove in gold prices from$100 per ounce in 1975 to$850inJanuary1980.

By1998thepriceofcrudeoilhaddroppedto$11andin1999goldhaddeclinedtothe$250 level. From therecommodity prices started tomove upward, partly inresponse to growth in

emerging economies likeIndiaandChinaandpartlyinresponse to liquiditysuppliedby central banks to cushionthe deflation of the stockmarketbubbleduringthebearmarket of 2000-2002. By2008 agricultural prices hadmoved well above the highlevelslastseenin1973-1974.Gold had moved above$1,000 and crude oil in July2008tradedat$147.

Thesespectacularmovesincommodity prices haveencouraged the developmentof investment crowds in oil,gold,andvariousagriculturalcommodities. My reading ofthehistoricalrecordleadsmeto believe that we have seenby far thebiggest part of therun-up in commodity prices.(This is being written inAugust 2008.) Over thecoming years these markets

willremainveryvolatileevenas prices should movedownward to moresustainable levels. Theseadjustmentswillseethebirthand disintegration of manyinvestment crowds in relatedmarketsandshouldprovideawealth of opportunities forthecontrariantrader.

INTERESTRATE

MOVEMENTSANDTHEBONDMARKET

During the past 30 years thedevelopmentofnewfinancialinstruments, principally themoney market fund andadjustableratemortgages,hasbrought the behavior ofinterest ratesandof thebond

market to theattentionof thegeneral public. This meansthat the contrarian trader canoften identify investmentcrowds in the bond market,especially after a long movein interest rates upward ordownwardhasoccurred.

Onecontrarianindicatorofthe stock market boom thatproperly began in 1982 wasthepopularity thenofmoneymarket funds, which were

regarded as fail-safe vehiclesfor assuring a prosperousretirement. In 1982 peoplehad come to believe thatannual returns of 10 percentor more on money marketaccounts were the norm andnot the exception.Simultaneously a hugebearish crowd had formed inthe bond market. Its themewas that high inflationwas aperpetual feature of the

economic landscape and thatholding long-termbondswasan invitation to capital loss.Long-term bond prices hadreached their historical lowpointsinSeptember1981andlong-term interest rates theircorresponding historicalhighs.

The bearish investmentcrowdinthebondmarketwasso adamant in its views thatin late 1982 I was prompted

to publish a bond marketprediction.InitIassertedthatthe 1981 highs in long-terminterest rates would not beexceeded for many years tocome. I predicted that bondprices would advance andlong-terminterestrateswouldfall for 25 to 30 years. InSeptember 1981 the 30-yearTreasury bond yielded 15.30percent,andwhenIpublishedmy prediction the yield was

around11.00percent.Bylate2008theyieldhaddroppedto3 percent, the lowest seen inmore than fiftyyears. I thinkthe bullish bond marketcrowd is about to begin itsdisintegration. If I am rightabout this I don’t think wewill again see treasury bondyields this low during thenextthirtyyears.

USINGYOURMEDIADIARYTO

TRACKINVESTMENT

THEMES

If you faithfully maintainyourmediadiary,itwillbeatreasure trove of informationabout the latest popularinvestment themes. I suggest

youtrytousethecategoriesIhavediscussedinthischapterto organize the themes youfind in your diary. One wayto do this would be write innext to each diary entry thename of the category or thespecific themeyou think thatparticular piece of mediacontent reinforces. You mayalso want to keep a separateindex of themes. In such anindex you would keep a

separatepage foreach themeyou have identified and arefollowing.Onthispagewritein chronological order thedate and a very briefdescription of every diaryentry that reinforces thetheme.The advantageof thisapproachis that itwillrevealat a glance just how muchattention each theme isgetting from the media, andthiswillhelpyoutojudgethe

size and importance of theassociated investment crowd.You will also find thisinformation helpful indetermining the intensity ofthe crowd’s beliefs, and thissort of information is veryhelpful in determining justwhere thecrowd is in its lifecycle.

CHAPTER10

InterpretingYourDiary:MarketSemiotics

Market crowds andinformation cascades

• the role of themassmedia • your mediadiary • semiotics, thestudy of signs •reading between thelines • role of theprice chart • PaulMontgomery andmagazine coverstories • Timemagazine’s coverstorymarkstheendofthebearmarket•read

the newspaper • theimportance ofheadlines•frontpagestoriesandeditorials•crystallizing events •weighing theevidence•moresemiotics

MEDIAANDINFORMATIONCASCADES

Market crowds are built byinformation cascades. Theway to detect a strong orgrowing market crowd is toobservedirectlyitsassociatedinformation cascade. Theamazing thing is that thecontrarian trader can do thissimply by monitoring thecontent of the mass media.The informationcommunicated in a cascadedoes not flow principally

through private, person-to-person channels. Instead, themassmediaactas thehubofa global communicationsnetwork that facilitates thecommunication that sustainsan information cascade.Individuals communicatewith this media hub (andindirectly with each other)every time they read anewspaper or magazine orconnect with the Internet to

check the content of theirfavoritewebsites.

Whyisthisso?Rememberthatthemediaareinanever-ending competitive strugglefor readership and for theattendant advertisingrevenues. To attract readers,the media must provideinformationandothercontentthat people will find topical,relevant, and interesting.Themedia are in the business of

tellingtheirreaderswhattheywant to hear. To survive inthis very competitiveenvironment, themediamusthave very sensitive antennaetuned to the interests andconcernsoftheiraudiences.

From this it follows thatthemedia act aswonderfullyreflective mirrors to publicopinion. But they playanother important role aswell. In the process of

mirroringpublicopiniontheyamplify and focus it bybringing this opinion to theattentionofotherswhodon’tyetsharetheconsensusview.Inotherwords,themedianotonlyreportontheprogressofan information cascade, theyamplify and strengthen thecascadeitself.

YOURMEDIA

DIARY:ALIVINGHISTORYOF

INFORMATIONCASCADES

Your media diary will serveyou as a real-time history ofinformation cascades. JustfollowtheguidelinesIsetoutfor you in Chapters 7 and 8.Be sure to keep your diary

up-to-date. As you put newentries intoyourdiary, try toassociate each one with aspecific investment theme.Note the themeofeachdiaryentry in the diary itself or, ifyou prefer, keep a separateindexofthemesandthedatesand content of the associateddiaryentries.Ithinkyouwillfind that most of your diaryentrieswillbeassociatedwiththe types of themes I

discussedinChapter9.

If you follow theseprocedures,yourmediadiarywill become a living historyof ongoing informationcascades in the financialmarkets. But your diaryentries will need furtherinterpretation if they are tohelp you judge the currentstrength and stage ofdevelopmentoftheassociatedmarket crowds. This art of

interpretation I like to callmarketsemiotics.

SEMIOTICS:THESTUDYOFSIGNS

Whataresigns?Probablythefirst examples of signs thatcome to mind are the signswe encounter daily whennavigating the road to work

or when finding our wayaround an unfamiliarbuilding. These signs oftendisplay information in theform of text and/or familiarsymbols. Sometimes thesymbolisjustacolor(aswitha traffic light) or an arrowpointinginsomedirection.Ingeneral, a sign is somethingthatstandsinfororrepresentssomethingelse.

Let’s consider the traffic

light example a little morecarefully. Why is the colorred associated with thecommand“stop”?Thismightsimply be a convention thathas developed over manyyears. Any other color couldhavebeenassociatedwiththecommand to stop as well.However, one might alsosuspect that there arephysiological reasons for theassociation of the stop

commandwith the color red.Perhapsthecolorredismorelikelytostandoutamongthecolors typically encounteredin nature or in humanenvironments and thus ismore likely to attract aperson’s immediateattention.Inanycase,thecolorredhasacquired an association withthe command “stop” or thewarning“danger,”evenwhenit appears in completely

different contexts—amagazine headline, forexample. The color red cannow be interpreted assomething that stands for thecommand to stop.But it alsohas become something more—ithasbecomeasignorthealertfordanger.

Semiotics is the study ofsigns, of things that stand infor or represent other things.Most signs typically have

manylayersofmeaning.Thefirst is the layer holding theobvious content or theintendedmessageofthesign.But there are often deeper,hiddenlayersofmeaningthatarise from the sign’s use inothercontexts.

Let’s take a newspaperheadline as an example.Suppose we open themorning paper and see aheadline that reads, in big

block letters, “Stock MarketCrash.” What are the layersofmeaningof this sign? It isasign,afterall—it isnot thestock market itself! The firstlayerofmeaningiscontainedin the obvious content of themessage: The stock markethas dropped. A second layerof meaning is conveyed bythe use of the word crash.This word has a verydramatic and unpleasant

connotation associated withphysical destruction anddeath. Yet a third layer ofmeaning arises from the factthat this sign takes the formof a headline. It is the firstthing most readers willnotice.Thenewspapereditorsmust believe this event isimportant and that it hasattractedtheattentionoftheirreaders and of the generalpublic. Moreover, they must

think that even the casualreader’s interest will bepiqued by the headline. Afinal layer of meaning isconveyedby the fact that theheadline is set in big blocklettering. This signifies thatthe message is even moreimportant than usual andmoreover often is associatedwith the presence of somedanger.

Sowehavepeeledawayat

least four different layers ofmeaning in our hypotheticalnewspaper headline “StockMarket Crash.” You mightsay that we have readbetweenthelinesofthispieceof media content. I like tothink of semiotics as the artof reading between the lines,of extracting meaning fromthe form, context,placement,and associations of a mediamessage as well as from its

superficialcontent.

Whymight it be useful tolearn the semiotic art ofreading between the lines?Ourgoalascontrariantradersis to identify market crowdsthat are near the point ofdisintegration. It is at thispoint that the crowd displaysextreme mental unity. Thisunity is associated with ahomogeneousandheightenedemotional state of the

crowd’smembers.Now,mostmedia content purports toconvey just the facts.Butweneed to identify the strengthoftheemotionshidingbehindthe facts. It is the strengthofthese emotions that identifiesthe point where a marketcrowd is liable to begin itsdisintegration.

Here is where thesemiotician’s skill atinterpretingsignsandreading

between the lines plays acrucial role, for the emotionsof a crowdare rarely seen inthe substance of the news.Instead they show up, as itwere, between the lines, inthe deeper layers ofmeaningconveyed by the content’smediaplacement,theformofthecontent, associatedcolorsand pictures, or choice ofdescriptive vocabulary,amongotherclues.

THEMOSTIMPORTANTSIGN:

THEPRICECHART

Let’s start with an obviousobservation. In life, the “up”direction is a happy one andthe“down”direction isasadone.Wewantmore,not less,ofanythingweconsidergood

ordesirable.Thesameistrueofmarkets. A stock or stockmarket average that isadvancing in price ismakinginvestors happy, but one thatis dropping in price isbringing pain to the sameinvestors.

The first sign we look forto help identify a bullish butaging investment crowd is aprice chart that shows adramatic upward trend in

prices; the longer and moresubstantial the advance inprices, the more likely it isthatabullishcrowdisnearingitsdemise.Howcanwegivequantitative meaning to thewords longer and moresubstantial? In Chapter 6 Ioffered a method fortabulating a market’shistorical swings. Thismethod will enable you toidentify the approximate

time-price zone in which amarketislikelytobemakinga valuation mistake. In allcases, high points will beassociated with chartsshowingpricesthathavebeengoing up for someappreciableamountoftime.

Without a bullish-lookingprice chart, no bullishinvestmentcrowdcanform.Itistheappearanceofthepricechart—the fact that prices

have been advancingsignificantly and for anappreciableamountoftime—thatbuttressesthelogicoftheinformation cascade andentices people to join aninvestmentcrowd.

Naturally,exactlythesameconsiderations apply tobearish-looking price chartsand bearish investmentcrowds.

These observations mayseem obvious, but I cannotoveremphasize theirimportance. The market’spricechartandtheassociatedhistoricalpricetabulationsarethe starting point of anycontrarian analysis you do.Remember that there can benobearmarketunlessthereisfirst a bull market, and nobull market unless there isfirstabearmarket.

Newcomers to the art ofcontrarian trading are oftenconfused by the fact that inany market at any point intime there are always somebullish and some bearishvoicestobeheard,eachwithits own plausible argumentsandrationales.Thisisonlytobe expected. After all, if amarketisanactiveone,theremustbeplentyofbuyersandsellers participating every

day.Therearealways lotsofbears and bulls at hand. Theart of contrarian tradingrequiresthatyoulearnhowtoidentifythesideofthemarketthat is operating as a crowd,unified in its marketrationales and emotions. It isonly human nature that thissideofthemarketwillbetheone associatedwith themostrecent, strong, and durabletrend in the market price:

upward for a bullish crowdand downward for a bearishone.

If you keep the semioticsignificanceofthepricechartin mind, you will avoid twovery common errors novicecontrariantradersmake.

The novice’s first mistakeis to cherry-pick mediacontent that disagrees withhisownmarketview.Onthis

basis the novice can oftenpersuade himself that hismarket view is a contrarianview,evenifhismarketviewin fact makes him part of agrowing investment crowd.You are much less likely tomakethiskindoferrorifyoukeep in mind the kind ofmarket chart that is typicallyassociated with a bullish orwith a bearish investmentcrowd. The chart is

essentially an objective pieceof information, at leastwhenseen from a broad-brush,semioticpointofview.

The novice’s secondmistake is to seize upon aprominent bullish story thatappears very early in a bullmarket or a very prominentbearish story that appearsearly in a bear market andconcludethatthenewtrendisabouttoreverse.

The most spectacularinstance of this in mymemory occurred in August1982, just as the DowIndustrials began the bullmarket that would carry thisaverage from 777 to 11,750by theyear2000.AnAugust1982 issue of Barron’sweeklyhadapictureofarip-snorting bull on its cover.Certain bearish marketprognosticators of the time,

Joe Granville in particular,interpreted this cover as asureindicatorofanimminentmarketdrop.Howwrongtheywere!Andalookatthechartof the Dow would haveshown that this contrarianinterpretation of theBarron’scover story was wrong-headed. The Dow had beendroppingforwelloverayearandhadbeen turningupwardforonlythreeweeks!

A second, almost asinteresting example of thisphenomenon occurred inApril2000,justamonthafterthe very top of the stockmarket bubble onMarch 24,2000. The April 24, 2000,issueofNewsweekasked:“Isthe Bull Market ReallyOver?” For reasons evidentfrom other details of thecover, Newsweek wasbegging for the answer yes.

Anditwasover!

So cover stories are notalways wrong. Sometimestheyareeerilyprescient.Thissort of novice error can beavoidedby remembering thatabullishmarketcrowdformsonlywhenthemarketchartisobviously showing a stronganddurableupwardtrendandthe market tabulationsdescribed in Chapter 6 warnof potential overvaluation.

When the Barron’s coverappeared in1982, themarketcharts of the stock averagesshowed either a bearish or aflat longer-run trend. Therehadnotbeentimeenoughandprices had not rallied farenough for a bull marketcrowd to form. So theexperienced contrarian traderhadnoreasontodrawbearishinferences from theBarron’scover. When the Newsweek

cover appeared, the marketchart was still pointingupward.Sonobearishcrowdcould yet have formed, andthus there was no reason forthecontrariantraderstodraw(long-run) bullish inferencesfromthiscover.

MAGAZINECOVERSTORIES

The pioneer in cover storyinterpretation is PaulMacraeMontgomery. In the 1970sMontgomery originallydeveloped his theory ofcontrary opinion analysisusing the archive of Timemagazinecoverstories.Sincethen he has expanded uponthis very original idea anddeveloped it into a practicaltheory of the psychologicaland emotional sources of

market fluctuations. I havelearned a lot from Paul, andmanyofmy ideas have beeninspiredbyhiswork.

Next to the semioticinterpretation of the marketchart, the most convincingpiece of evidence that amarketcrowdisamatureoneisanunusualmagazinecoverstory associated with thecrowd’s investment theme.The meaning of the term

unusual in this contextdepends on the source of themedia content. For example,it is unusual for Time,Newsweek, or other generalinterest weekly or monthlymagazines topublishacoverstory associate with afinancial market. So suchcover stories are especiallyindicativeofamaturemarketcrowd. However, BusinessWeek and Fortune both

specialize in business andfinancial news, so financialcover stories in thesemagazinesarenotsounusual.The Economist is more of ageneral interest magazinethan it used to be, but it stillemphasizes a business andfinancialviewofworldnews.

Notethatamagazinecoverstory might not concern themarketdirectly,but ratheranindividual closely associated

withit, forexampletheCEOofanindustrythathasbeenabullmarketleader.

An important example ofthis phenomenon occurredwhenTimemade Jeff Bezos,founder of Amazon.com, itmanof theyear inDecember1999. Bezos personified thenew economy theme of thestock market bubble thatpeakedinMarch2000.Wheninterest ratesare the focusof

a market crowd, theappearance of the chairmanof the U.S. Federal Reserveon the cover of Time orNewsweekwouldhavespecialsignificance. In March 1982Time magazine featured thethen Fed chairman, PaulVolcker,onitscoverwiththecaption “Interest RateAnguish.” The bond marketwas scraping bottom at thetime, and long-term interest

rates were close to theirhistorical highs (reached onSeptember 30, 1981). Thatcovermarked the start of thedisintegration of the bearishbond market crowd. Theresult was a bull market inbondsandadropinlong-terminterest rates that lasted 25years.

Magazine covers can be atreasure trove of semioticinformation about market

crowds. Here is anillustration.MyfavoriteTimecover of recent years is itsJuly 29, 2002, cover. Thisissue hit the newsstandsalmost on the exact day thatthe S&P 500 traded at 771.This average then rallied to965 before dropping to anearlyOctoberlowat768.Thecover itself showed agrandmother on roller skatesworkingasacarhopatafast-

food drive-in. The coverasked: “Will You Ever BeAble toRetire?” The subtitleread: “With StocksPlummetingandCorporationsin Disarray, Americans’Financial Futures Are inPeril.” (Emphasis is in theoriginal.)

Here is my semioticanalysis of this cover. First,the chart of the marketaverages was pointing

downward. Stock prices hadbeendroppingforalmosttwoand a half years and hadfallennearly50percent fromtheir highs. The NASDAQComposite had fallen nearly80 percent. My tabularanalysis indicated that themarketwas probablymakinga mistake of undervaluation,so it was very likely that astrong bearish crowd was atwork.

This Time cover providedincontrovertibleevidencethatthere was indeed a bearishcrowd and that it was in alllikelihood amature one. Thecover had several layers ofmeaning. First, it affirmedthat stocks had beenplummeting, something thatanyone could see from hisbrokerage statementsor fromthe chart of the averages. Italso affirmed that

corporationswere in disarraybecause of widespreadaccountingfraudandpensionplan underfunding due to thestock market drop. So thiscover was associated withtwo prominent investmentthemes: the plunging stockmarketthemeandthecorruptcorporationtheme.

The cover pushed severalemotional buttons as well.This is a very important

aspect of market semiotics.Market crowds have strongemotional attachments totheir investment themes. It isthisemotionalattachmentthatgives the crowd its mentalunity. So when analyzingmedia content always payspecial attention to theemotional aspects of themessage. In the case of thisTimecoverwenoticetheuseof the word plummeting to

describe stock prices.Americans’ financial futuresare inperil.Corporations arein disarray. All three wordshave unusually negativeemotional associations andconnoteasituationthatisoutof control, a time ripe forpanic.Thecoveralsoplaystothefearallretiredorsoon-to-retire people have for theirfinancialfutures.Willtheybeable to live out their lives

without being reduced topoverty? The cover asks:“Will You Ever Be Able toRetire?” It suggests that thisis not a good time to retireand that the plummetingstock market has made itlikely youwill have to workmenialjobsforagoodpartofyour retirement to survive.This appeal to a generalizedfear for your future is asecond and very important

emotional button that thiscover pushes. To top this alloff, the central characterdepicted on the cover wasgranny, a helpless victim ofcorporate greed and WallStreetmalfeasance.

The emotional messagesthat are this cover’s subtextconvincedmeatthetimethatthis bearish stock marketcrowdwas forcing amistakeof undervaluation. I believed

then that a new bull marketwas just around the corner.The S&P 500 index doubledduringtheensuingfiveyears.

NEWSPAPERHEADLINES

The major metropolitannewspapers are publishedseven days a week and 52

weeks a year. Every issuecontains a lead headline onthefrontpage.Rarelydosuchheadlines concern a financialmarket. When they do, thecontrarian trader sits up andtakesnotice.Such a headlineis convincing evidence of amarketcrowdatworkandofa contrarian tradingopportunityathand.

Howdoesoneuncover theemotional content of a

headline? The first and mostobvious aspect of anyheadlineis itsprominenceonpage 1. Some headlines areconfined to the right-handside of the newspaper andappear only at the top of theassociated story. Otherheadlines are spread acrossthe topofpage1andare forthis reason of much moreemotional significance. Theemotional content of a

headline is also emphasizedbythetypesizeinwhichitisprinted. Big, bold, blocklettering has much moreemotional impact thansmaller lettering. A headlinecan also be emphasized by aphotograph or a chartappearing near it. The valueof this sortof cluecannotbeunderestimated.

Theemotionalcontentofaheadlinecanalsobefoundin

thechoiceofwordsappearingin its text. Words associatedwith fear, uncertainty, andother negative emotionsspeak for themselves andshould be noted. Wordsdenoting exuberance,confidence,hope,joy,andthelike are also significant,though far less common innewspaper headlines. Hereare a few recent examplesthat illustrate the application

oftheseprinciples.

The headline for theJanuary17,2008,issueoftheNew York Times read: “FedChief’s Reassurance Fails toHaltStockPlunge.”Let’sputthisheadlineinthecontextofamarketchart.TheS&P500index had reached a high at1,576 on October 9, 2007,and had dropped as low as1,364 the previous day,January 16, 2008, for a drop

of about 14 percent in threemonths. According to themarkettabulationsIdiscussedinChapter6,thiswasnotyetasituationassociatedwithanimportant long-termundervaluation mistake. Sothe contrarian trader wouldnot have taken this headlineas evidence of amature bearmarket crowd at work in thestockmarket.

Asimilarconclusionarises

from a semiotic look at theheadline. First, the headlinewasspreadoveronlythefirsttwo columns of thenewspaper and its type sizewasnotatallunusualfor thetypical headline. There wassome significant emotionalcontent,ascanbeseenbytheuse of the word plunge andby a photograph appearingright underneath the story ofthe Fed chairman as he

appeared on TV. Thephotograph was captioned:“Ben S. Bernanke’s faceloomed over the ChicagoBoard of Trade.” The use ofthe word loomed in thiscontextevokedtheimageofaghostly, larger-than-lifesuperbeing speaking to hissubjects. I note also that theheadline states Bernanke’sreassurance failed (myemphasis), and this

undermines one’s confidencein the benevolent powers ofthissuperbeing.

Not even a week later, amore dramatic headlineappeared. The January 22,2008, issue of theNew YorkTimeswasheadlined:“WorldMarkets Plunge on Fears ofU.S. Slowdown.” It isinstructive to compare thisheadline to the January 17headline. The January 22

headline was spread acrossfour columns instead of justtwo. It appeared in largertype. Right underneath theheadline were three colorphotographs. The first andlargestshowedanimageofachartoftheNikkei225indexfortheJapanesestockmarket.It depicted yellow bars on ablue background and showedtheaveragedroppingsteadilylower. The other two

photographsweresmallerandshowed people around theworld reacting to the plunge.The fact that there werephotographs associated withthe headline emphasized itsemotional content, and thefact that the photographswere in color doubled thisemphasis.

The next day, January 23,sawanotherNewYorkTimesheadlineconcerningthestock

market.Thisonewasinevenbigger and bolder type thanthe previous day’s, althoughit was spread over only twocolumns. However, itappeared alongside severalgraphs, and the entire storywas spread across the entirefront page. These details allindicated a more powerfulemotional state for a bearishstockmarketcrowdthanwasindicated by the previous

day’s headline. The January23 headline read: “Fed, inSurprise,SetsBigRateCuttoEaseMarkets.”

By January 23 the S&P500 had dropped 20 percentfrom its top on October 9,2007.Thisputitonthefringeof potential undervaluationaccording to the pricetabulations of Chapter 6,although the drop had lastedonly three months, rather a

short time for a significantbearish market crowd toform.Sothecontrariantradermight anticipate a relativelyshort-term bullish tradingopportunityhere.At theveryleasthewouldnotbetemptedto join the bear crowd bysellingstocksatthisjuncture.

FRONTPAGE

STORIESANDEDITORIALS

Headlines convey verysignificant information aboutmarket crowds to thecontrarian trader. Butsometime a market-relatedstory appears on the frontpage of a newspaperwithoutbeing the headline. Suchstories provide additional

evidence for the existenceand strength of a marketcrowd, so I make a point ofputting them intomymarketdiary, too. The semioticprinciples of interpretationarethesameasforheadlines.The additional bit ofinformationthatcanbeusefulconcerns the story’splacement on the front page:Being close to the top of thepage (above the fold is the

most significant placement)and positioned to the far leftor far right of page 1increases the weight oneshouldgivetothestory.

Anothersourceofevidencefor market crowds at workcanoftenbefoundonthefirstpage of the paper’s businesssection. Headlines here,especially if accompanied byphotographs, are importantmaterial for your diary.

However, they do not carrythe same weight they wouldhave if they appeared as theheadline on the paper’s frontpage.

Very occasionally ageneral interest newspaperwill print an editorialdiscussing the situation insome financial market.Because this is so unusual Iam careful to paste sucheditorialsintomymediadiary

and use them to assess thestrengthofmarketcrowds.

CRYSTALLIZINGEVENTS

Veryoftenitwillhappenthatan investment crowd’s viewswill be reinforced andapparently vindicated bysome event external to the

marketitself.Theoutbreakofwar, the signing of a peacetreaty, thefailureofbanksorother financial institutions,corporate bankruptcies, andcurrency devaluations are allexamples of such events. Ilike to think of these eventsas things that crystallizeinvestor sentiment. Theyharden beliefs that until thenmay have been only weaklyarticulated and defined. As

such, crystallizing events aregenerally associated with theimminentdisintegrationofaninvestmentcrowd.Idiscusseda number of examples ofcrystallizing events inChapter 9. Be alert for themas signs that a valuationmistakeisbeingmade.

Along the same lines, oneshould pay special attentionto situations in which themediaholdoutindividualsas

exemplars of market orbusiness success or failure.During the late 1990s, at theheight of the stock marketbubble, there was a constantstream of media storiesdescribing in great detail thewealth and lifestyles of thenewly minted Silicon Valleymillionaires. In 2002, duringthedepthsof thebearmarketthat followed the bubblecollapse, most of the bullish

analysts who helped inflatethe bubble and many of thecorporateleadersofcollapsedenterprises were pilloried inthe media. This was asymptom of stock marketundervaluation.

THEWEIGHTOFTHEEVIDENCE

So far I have discussedvarious methods andapproaches for analyzingmedia content. I have takenthe view that this contentconsists of signs with manylayersofmeaning.Thejobofa contrarian trader is to peelawaytheselayersofmeaning,always looking for theemotional significance ofeverysign.

How much media and

semiotic evidencemust therebebeforethecontrariantradercan be confident that he hasidentified amarket crowd onthevergeofdisintegration?Isthere some mathematicalformulaorguideline that canbe applied to this process tomake it more objective, toenable one to weigh themedia evidence in someobjectivemanner?

Idon’tbelievethereisany

simple criterion or formulathat can provide reliableanswers to these questions.Over the years I have grownmore and more skilled atweighing the semioticevidenceonlybecauseIhavefaithfully kept up my mediadiary. This has givenme theopportunity to makecomparisons among similarhistorical market juncturesand the intensity and

frequency of the mediacontentassociatedwiththem.So I think the best way todevelop the semiotic skillsyou need for identifyingmarket crowds is to practice.Real-time practice can bereinforced by readingaccounts of past bubbles andbearmarket lowpoints.Suchhistorical information willgive you a sense of theconditions and the nature of

public opinion associatedwith mature investmentcrowds.

One might naturallybelieve that the bigger thevaluation mistake, the morepages of one’s market diaryone will find devoted to thecommunications of theassociatedmarketcrowd.Butthere are times when a bigvaluation mistake is beingmadebyamarketcrowdeven

though only a few (butimportant) media storiesappeartoconfirmit.Thiswasthe case at the bottomof thebear market in 2002. Therewas certainly a generalbearish malaise at the time,but only the Time magazinecover story in July of thatyearandaNewsweekAugustcover story pointedspecifically to the marketlow. So a contrarian trader

mustbecarefulnot toexpecta blizzard of cover storiesand/or newspaper headlinesto announce the imminentdemise of an investmentcrowd.Sometimes just a fewpiecesofevidencewilldothejob, and the volume ofevidence is not necessarilycorrelated with thesignificance of theopportunity. This is oneimportant reason why

contrarian trading is at leastas much art as it is science.And an artist’s skills requireconstant practice to developandmaintain.

MOREONMARKET

SEMIOTICS

You should not take theguidelines I have offered inthis chapter as the last wordon the interpretation of yourmarket diary. As thecontrarian trader gainsexperience, his creativitybegins to inform his work.Over the years I’ve made anumberofobservationsaboutthe signs associated withmarket crowds.Here are twoexamplesthathavehelpedme

andmaywellhelpyouinthefuture.

Consider first thepublishing industry. It canprovide the contrarian traderwith useful clues about theexistenceofmarketcrowds.Iremember back in the late1970s and early 1980s whenbookstores had only one ortwo shelves devoted to thestockmarketorinvesting.Bycontrast, at the peak of the

stock market bubble in 2000Barnes&Noblehadeasily20or more shelves devoted tothesubjectofinvesting.Evenmore telling, therewereverymany titles on subjects likeday trading or technicalanalysisthatwerenotevenofinterest 20 years earlier. Asonemight expect, during theeight years subsequent to the2000 bubble top, the shelfspace devoted to books

related to the stock markethasshrunkdramatically.Thisis a very good indicator ofdeclining public interest inthestockmarket.

Along the same lines, onecan keep track of new booktitles that appear on thesubject of investing andrelated financial matters. Atleast three books predictingDow levels ranging from30,000 to 100,000 were

published right at the top ofthe 1994-2000 stock marketbubble, and this was adefinitive indication of amature bull market crowd.(The topof theDow in2000was 11,750, and the top in2007was14,164.)Isuspectasimilar phenomenon isoccurringasIwritethisinthefall of 2008. A number ofbooks have recently beenpublished or are forthcoming

that discuss the subprimemeltdown in the financialmarkets over the past year. Ithink this means that apowerful bearish stockmarket crowdhasdeveloped.If so, this is a tremendousbuying opportunity in theU.S.stockmarket.

Another interesting sign isa very subtle one, butnonetheless it is of greatimportance. An information

cascadeattractsnewmemberstoamarketcrowdbyofferinga rationale or logicalexplanation for past andfuture market performance.Thecascadehere isacting ina persuasive role,encouraging investors toaccept the crowd’sinterpretation of eventsinstead of their own. But apointiseventuallyreachedinthe lifeofeverycrowdwhen

these rationales becomepremises instead ofexplanations. The time forlogical argument has passed.In other words, what wasonce offered as anexplanation for a risingmarket, say, at some pointbecomes accepted as a fact,not a theory. As such it nolonger needs justification orsupporting argument. At thisjuncture the crowd’s beliefs

have become the axiomsupon which all of itsdiscussion and actions arebased. The crowd hereachieves its mental andemotional unity. Itsdisintegration lies not farahead.

It is possible to detect thistransition by observingcarefully the balance thatmedia content maintainsbetween an effort to justify

the crowd’s beliefs and thebestwaytotakeadvantageofthe beliefs’ investmentimplications. In the latestagesofacrowd’slifecycle,virtually all of the contentwill be devoted to methodsfor exploiting the market’sprojected movements, not toexplanations of why thesemovements should occur atall.

CHAPTER11

TheGrandStrategyofContrarian

Trading

Becoming acontrarian trader •

learnbydoing • startsmall • a word toyoung readers • putyourself in the line offire • my experienceasapostcardtrader •investment vehiclesforcontrarian trading• the advent of theexchange-traded fund(ETF) • investmentgoals •no need to beperfect • an example

from the boom andbust 1990-2002 • taxissues•CTS#1:don’tspeculate•whythisisreally a contrarianstrategy • CTS #2:avoid big mistakes •inoculate yourselfagainst crowdcontagion • CTS #3:ContrarianRebalancing •underweight when a

bullish crowddevelops • overweightwhenabearishcrowddevelops•anexample• best strategy tofollow for the typicalaspiring contrariantrader • suggestionsfor more aggressivecontrarian tradingstrategies • anaggressive stockmarketstrategy • look

at bonds,commodities, stockmarket sectors, andindividualstocks•it’sharder to track thecrowd in suchsituations • thebandwagon strategy •the danger of tryingthe short side of amarket • the oddsfavorthestockmarketbullsinthelongrun

CONTRARIANINVESTMENTPLANNING

InthischapterIwanttoshowyouhowtotaketheideaswehave developed in thepreceding 10 chapters andincorporate them into acontrarianinvestmentplan.

Every contrarian trader

begins as a novice. As anovice, the best approach isto startyourmediadiaryandto spend time constructingmarkettabulationsof thesortIexplainedinChapter6.Youshould also think about thetypesofinvestmentstrategiesIdescribe in thischapterandchooseonethatsuitsthetimeyou can devote to yourinvestments.Ihavefoundthatlearningbydoingis themost

effective way to acquire theskillsofasuccessfultraderorinvestor. Making decisionswhen there is real money atstake is the essence of theexperience and the only wayto find out whether youremotionalmakeup is suitableto the contrarian approach tomarkets.

With this in mind, Isuggest that you begin yourlearning-by-doing phase by

starting small.Devote only asmallpartofyourinvestmentportfolio to a singlecontrarian trading strategy.After a two- or three-yeartesting period, compare yourcontrarian trading results toyourotherinvestmentresults.If the contrarian results arevisibly superior, earmarkmoreofyourportfoliotoyourcontrariantradingstrategy.

A word to my younger

readers: At this moment youmayhave littleornosavingsthat can be devoted toinvestments of any kind, letalone to contrarian trading.Butthereisstillalearningbydoing opportunity for you todevelop your contrariantrading skills. In addition toyour media diary, keep anotebook in which to recordspecific buy and selldecisions without making

actual trades. This is calledpapertradingorinvesting.

Itisevenbetterifyouhavea friend towhomyou can e-mail your investmentdecisions in real time, justasyou would buy or sell in anelectronic market. Ask yourfriendtokeepafileofyoure-mail “orders.” This is theclosest you can come to theactual experience of riskingrealmoneyonyourdecisions,

and it is farbetter thanpapertrading,whereonlyyouknowifyouhavecheated.

WhenIwasstartingoutasacontrariantraderincollege,Imailedapostcardeveryfewweeks to a very experiencedand successful moneymanagerwhohappenedtobea family friend. On thispostcardIwouldgivebuyingandselling instructionsbasedon the market average. The

experimentlastedonlyayear,but it was an invaluableexperience.Somethingwasatstake:myowncredibilityandpride, something as valuabletomeasmoney (ofwhichatthe time I had none!).Because I had something atrisk when I made mydecisions and mailed thepostcards, I experiencedsomething very similar toriskingrealmoneyagainstan

uncertainprospect.Ifyoucando this, even if no actualmoney is at stake, you willacquire a treasure trove ofexperience in interpretingyour market diary andidentifying potential marketmistakes.Youwill also learnalotaboutyoursuitabilityforcontrarian trading. Later,whenyouhavesavedenoughto begin an investmentprogram, your skills and

experience as a contrariantrader will have beendeveloped to thepointwherethey will make a visible,positive contribution to yourinvestment results. So don’tpass up this opportunity tobuild your investment skillsnow. Prepare them for usewhen you have money toinvest!

CONTRARIANTRADER’S

INVESTMENTPORTFOLIO

What kind of assets aresuitable vehicles for acontrariantrader’sinvestmentplan? The key thing torememberisthathisprincipaltool is his media diary. It

follows that the contrariantrader should focus onmarkets that receive thefrequentattentionoftheprintand electronic media. Thismeans that a typicalcontrarian trader will focusprincipally on stock marketandbondmarketinvestments.

But opportunities in othermarkets sometimes arise.Occasionally there will be alot ofmedia attention on the

currencymarkets,particularlyontheU.S.dollar.Sometimesagricultural commoditiesmake it to the front pages ofnewspapersandthecoversofgeneral interest magazines.Over the past three or fouryearsthecrudeoilmarkethasattracted world-wideattention. During the sameperiod precious metals likegold and silver haveexperienced information

cascades that have built biginvestment crowds in thesemarkets.Inmyopinion,thesecurrency and commoditymarket opportunities aregenerallybestlefttotheveryexperiencedcontrariantrader.These markets usually moveveryquickly,andinvestmentsin them are typically highlyleveraged.Not only can theybe dangerous, but contrariantrading opportunities in these

markets arise onlysporadically. The typicalcontrariantrader’sattentionisbest focused on stocks andbonds, thebiggestmarkets intheUnitedStates.

Financial innovations overthepast20yearshavebeenaboon to thecontrarian trader.Up until the 1970s the onlyway to take advantage ofcontrarian tradingopportunities in the stock or

bondmarketaverageswas tobuy a portfolio of individualstock or bonds.Not only didthis involve high transactioncosts, but it made it difficultfor an investor of averagemeanstoconstructaportfoliothat was sufficientlydiversified to reliably trackthe market averages. Mutualfunds were generally notappropriate for this purposebecause of their high

management fees coupledwith so-called load charges.These expenses made themunsuitable for anything otherthan the buy-and-holdinvestmentstrategy.

In recent years thisfinancial landscape has beencompletely transformed, tothe delight of the contrariantrader and of the averageinvestor as well. Indexedmutual funds whose sole

objective is to replicate theperformance of the stock orbond market averages havegrown popular. They areavailable to the investingpublicatlowcostintermsoftheir management andtransactionfees.

Ofevengreaterimportanceto the contrarian trader hasbeen the emergence ofexchange-traded funds(ETFs). It is my view that

these are ideal vehicles forcontrariantrading.AnETFisan investment trust whoseshares are listed for tradingon an organized stockexchange like the AmericanStockExchangeandtheNewYork Stock Exchange. Thetrust holds a portfolio ofsharesdesignedtotracksomespecific market average andstands ready to exchange theshares in the trust for

portfoliosofindividualstocksthat make up that average.This exchange provisionmeans that arbitrage betweenthe ETF shares and themarket portfolio it tracks ispossible and will keep theprice of the ETF shares inproper alignment with itschosenmarketaverage.

By far the most activelytraded ETF at this writing isthe S&P 500 “Spider” ETF,

so-called because it tracksStandard&Poor’sDepositaryReceipts (SPDRs); its tickersymbol is SPY. There areother actively traded ETFsthat track other U.S. marketaverages,aswellassomethattrack sub-sectors of the U.S.stock market such as thefinancial sector, energysector, or precious metals.TherearealsoETFsthattrackvarious sectors of the bond

market. An even biggerinnovation has been thedevelopmentofinverseETFs,which rise in price when aspecific market average fallsand vice versa. However, Iurgeyoutobecautiouswhenbuying inverse ETF’s in thehopes of taking advantage ofa fall in some market.Because of the way inverseportfoliosareconstructedandmanaged, inverseETF’smay

failtomoveinverselytotheirindex exactly. Worse, inextreme circumstances theymayevenwindupmovinginthe same direction as theindex instead of inversely toit!

THEINVESTMENTGOALOFTHECONTRARIAN

TRADER

Thecontrariantrader’sgoalisto beat themarket. Butwhatdoes this mean in practicalterms? For most people,beating the market meansoutperforming the buy-and-hold investment policy. (Ifyouareanexpertinportfolioanalysis, you will probablywant to qualify this last

statement by adjusting forportfolio risk.) I want toemphasize that one need notsell near the exact top of abull market or buy near theexactbottomofabearmarketto beat the buy-and-holdstrategy. You need only doyourbuyingandsellinginthegeneral vicinity of these topsand bottoms. Here is anexample that illustrates thispoint.

Let’s imagine ahypothetical contrarian traderwhose noncash investmentsare all in an S&P 500 indexfund.During the first part ofthe 1990s let’s suppose hewasfully invested.Thestockmarket showed no realevidence of a bullishinvestment crowd until 1996at the earliest. Imagine that,for whatever reason, thiscontrariantraderconcludedin

1997 that therewasamaturebullish stock market crowdthatwasabouttodisintegrate.He therefore sold his entireportfolioatanaverageof950in theS&P. Ishouldsay thata contrarian trader whofollowed the ContrarianRebalancing strategydescribed later in the chapterwould not have sold untilearly2001,andthennear theS&P1,250level.HereIwant

to illustrate theexperienceofa traderwithonlyaverageorbelow-averageskills.

At what level in the S&Pmight this trader haverestored his original longposition? I think there was avery good contrarian buyopportunityintheS&P1,000to 1,050 range in October1998. But let’s suppose ourhypothetical trader passedthis opportunity up for some

reason. (Again, anexperienced contrarian traderwould have seized the 1998buyingopportunitywithbothhands.) Instead, let’s supposethatthistraderwaiteduntilhesaw the July 2002 Timemagazine cover (which Idiscussed in the precedingchapter) before deciding toreinvest his portfolio in thestock market. Let’s supposefurthermorethathedidthisat

an average of 900. (In fact,my wife, a complete novice,didthisatthe820levelatthattime.)

The net result of ourhypothetical trader’sdecisions was a sale in 1997at950andapurchasein2002at 900. Now, the yield onmoney market instrumentsexceeded the yield on theS&P by an average of 250basis points per year during

thisfive-yearperiod.(Abasispointisoneone-hundredthofa percentage point, so 250basis points is 2.50 percent.)So a tax-deferred portfoliosold at 950 in 1997 and theninvested in a money marketfund until 2002 would havegrown to a value equivalenttothe1,074levelintheS&Pandin2002wouldhavebeenreinvested at the 900 level.This represents a gain of 19

percent relative to the buy-and-hold strategy during thattime, or about 350 basispoints per year. Moreover,this was achieved by takingno market risk during thosefive years. In contrast, thebuy-and-hold strategy duringthose five years was fullyinvested throughout a bubbleof historical proportions andits ensuing collapse. I shouldpoint out that any

professional money managerwho beats the buy-and-holdstrategy by 300 basis pointsper year is a hero on WallStreet.

In my opinion ourhypothetical contrarian traderexhibited only average oreven below-average skillsover the 1990-2002 timeframe. Yet he did visiblybetter than themarketduringthe dangerous and very

difficult bear market periodof 2000-2002 and over theentire13yearperiodaswell.Hedidnotsellanywherenearan important top.His buyingwasmoreskillfullydone,butstill was nothing to bragabout.

This example illustratesthat to achieve market-beating results it is notnecessary to be anywherenear perfection in the timing

ofyourbuyand sell activity.The main thing is to haveenough portfolio liquidityavailabletotakeadvantageofbearish market crowds whenthey form. They are mucheasier to identify thanbullishcrowds and are usually verynear to disintegration oncetheycanbeidentified.

AWARNING

ABOUTCAPITALGAINSTAXES

The active contrarianstrategies described in thischapter will subject theinvestortocapitalgainstaxeswhen employed in a taxableinvestment account. Thesetaxes may affect thecontrarian trader’sperformance relative to the

baseline buy-and-holdstrategy. This issue demandscareful consideration beforeone adopts a contrariantrading strategy in a taxableaccount. In fact, for thisreasononlyexpertcontrariansshouldusesuchstrategiesinataxable account. Generally,contrarian trading strategiesaremoresuitedforuseintax-deferredretirementaccounts.

CONTRARIANTRADING

STRATEGY#1:DON’T

SPECULATE

Youmayhavefoundthefirstfew chapters of this book sopersuasive that you havedecided that contrariantrading is not for you. If so,

you have already achievedmore than many aspiringinvestors do in a lifetime.Congratulationsonyour self-knowledge! It will save youfrom many personally andfinancially painfulexperiences in the world ofinvesting.

Contrarian TradingStrategy #1 (or CTS #1 forshort) is: Don’t speculate.Instead choose an allocation

for your investment portfolioamong indexedmutual fundsorETFsthatmirror thestockmarket averages, the bondmarket, and money marketinstruments. A simpleexamplewouldbea60-30-10allocation among Spiders, abondmarket index fund, anda money market fund. Eachyear,atthesametimeofyear,take a look at your portfolioto see if market movements

during the past year havechanged your portfolio’sallocation away from itsdesired 60-30-10 allocation.Then do whatever buying orselling is necessary to bringyourportfolioback to60-30-10. If you do thissystematically, year afteryear, your investment resultswill be better than those ofthe typical professionalmoneymanager!

You may wonder why Icall this a contrarian tradingstrategy. Trading it certainlyis not. But it is a contrarianstrategyinthetruestsenseofthe word. How manyinvestors do you know whofollow it? Not many, I’msure.Why?Becausetofollowit you first must recognizethat you do not have aspeculator’s edge over otherinvestors.Goodforyou!Now

youcanspendmoretimewithyour family, pursue yourother interests, and not bebotheredatallbytheupsanddowns in market prices andpublicpsychology.

CONTRARIANTRADING

STRATEGY#2:DON’TINVEST

WITHTHECROWD

This is a somewhat moreactiveapproach thanCTS#1but is still in the spirit ofwinning by avoidingmistakes. It is an essentiallydefensivestrategy.ContrarianTradingStrategy#2is:Don’tinvestwith the crowd. If youcan avoid becoming part of

big investment crowds youwill also avoid the financiallosses attendant to a crowd’sdisintegration and collapse.Not only this; you will alsoavoid the foolish decisionsinvestors caught in suchcollapses often make thatcompound their mistakes(like keeping their money inmoney market fundsthereafter, or throwing goodmoneyafterbad).

In this contrarian tradingstrategy, your media diaryactsasan inoculationagainstthe information cascades thatbuildinvestmentcrowds.Youwill know that a cascade isunder way and see that themarket is in the process ofmaking a valuation error.Armed with this knowledge,you will not be tempted toincrease you portfolioallocation to the crowd’s

investment theme, especiallywhen the siren song of thecrowd is strongest. In thiswayyoucanavoidbiglossesin your portfolio when thecrowd inevitablydisintegrates. At the sametime you pursue whateverinvestment strategy youprefer, even if it is not anexplicitly contrarian one. Tobe a winner in the game ofinvestment, it is essential to

avoid big mistakes. FollowCTS#2andyouwillachievethatgoal.

CONTRARIANTRADING

STRATEGY#3:CONTRARIANREBALANCING

The strategy of ContrarianRebalancing aims to sidestepthe market collapses thatattend the disintegration ofbullish investment crowds. Italso tries to be overweightedin a market that isundervalued and in the gripsofabearishcrowd.ThisisthestrategyI thinkmostaspiringcontrarian tradersshoulduse.I think of it as a veryconservative strategy, and I

discuss more aggressivecontrarian trading strategieslater in this chapter. I thinkthat this strategy works bestwhen the contrarian traderhas chosen to limit hisinvestment universe to ETFsor indexedmutual funds thatmirror the stock and bondmarket averages. So let’ssuppose he adopts a baseline(normal) allocation of 60percent stocks, 30 percent

bonds, and 10 percent cash,the same allocation as wasused to illustrate CTS #1.(There is nothing specialabout these allocationpercentages. They are,however, the averageallocations of investors as agroup.) Here’s how CTS #3works in the stock market.During a bull market, anyabove-normal allocation tothe stock market should be

cut back to normal levelsonce the averages have risenabout65percentfromthelowoftheprecedingbearmarket.However,thisshouldbedoneonly if the advance has alsolasted at least 20 months. IthinktheS&P500isthebestmarket index tousefor thesecalculations.

When should the stockmarket allocation be cut tobelow-normal levels? The

worst mistake a contrariantrader can make is to beunderinvested in stocksduring an extended bullmarket. Such markets aretimeswhen thebaselinebuy-and-hold strategy performsbest. To avoid this mistake,the Contrarian Rebalancingstrategydictatesthatabelow-normal stock marketallocation can be adoptedonly in the following

circumstances.First,theS&Phas advanced at least 65percent from its precedingbearmarket low.Second, thecontrariantradermustbeableto identify a bullish stockmarket crowd from thematerial in his media diary.Finally, and mostimportantly, the 200-daymoving average of the S&P500must fall 1 percent fromwhatever high it has reached

during the bullmarket. (Thismoving average is calculatedby adding up the latest 200daily closes in the S&P andthendividingthetotalby200,aneasytaskinaspreadsheet.)This last requirement willkeep the contrarian traderinvested in stocks duringthoseraretimeswhenastockmarket bubble sends pricesupwardmorethananyonecananticipate.

HowdoesCTS #3 tell thecontrariantradertoactduringa bear market? If the bearmarket results from thedisintegration of a bullishstockmarket crowd that wasvisible toward the end of thepreceding bull market, thecontrarian trader would havecut back his stock marketallocation to below normalonce the 200-day movingaverageoftheS&Pdropped1

percentfromitshighpoint.Inall other circumstances thecontrarian trader would sitthrough a bear marketmaintaining a normal stockmarket allocation. In eithercase, once the S&P hasdropped 20 percent from itspreceding high point and abearish stock market crowdhasdeveloped, thecontrariantrader looks for anopportunity to increase his

stock market allocation toabove-normal levels. This hedoes once he observes the200-day moving average ofthe S&P 500 advance 1percent fromwhatever low itmakes after the drop of atleast 20 percent that hasencouraged the growth of abearishstockmarketcrowd.

THEAGGRESSIVE

CONTRARIAN

Incontrasttohisconservativecousin, the aggressivecontrarian trader willgenerally make two or morechanges to his stock marketallocation each year. Theaggressive contrarianallocation strategy I describenow is a long-only strategyandinvolvesnoshortsalesor

purchases of inverseexchange-traded funds(ETFs). There is a simplereason for this: Every tradercan benefit from specializingin one specific tradingstrategy and in using a smalluniverse of trading certaininstruments. In the case athand I am suggesting thatmost aggressive contrariansshouldfocusonincreasingordecreasing their stockmarket

allocations with the goal ofbeatingtheresultsofthebuy-and-hold strategy. The stockmarket part of theirinvestment portfolio shouldbe invested in ETFs like theDiamonds or Spiders (whichtrack the Dow and the S&Prespectively) that mirror theperformance of the majormarketaverages.Suchalong-onlystrategywilllosemoneywhentheaveragesareinbear

markets. But thepsychological demands itmakes on an individual aremuchmoremodestthatthosemade by a strategy thatallowsshortsales,too.

Every contrarian tradershould keep inmind that hisinvestmentgoalistobeatthemarket—that is, to do betterthan the performance of thebenchmark buy-and-holdstrategy. Sadly, I find that

many investors believe it ismoreimportanttoberight intheir guesses about theprospective direction ofmovements in the marketaverages. Nothing could befurtherfromthetruth.Infact,philosopherswould call suchan attitude a categorymistake.Rightandwrongareconceptsthathavenoplaceinevaluating investmentperformance. The only

conceptsthatmatterareprofitand loss, especially whenmeasured relative to someappropriate benchmark. Thecontrarian trader isemphatically not in thebusiness of detecting highpoints or low points in thestockmarket averages.He isconcerned only withuncovering market mistakesin a timely way and inmaking portfolio adjustments

that will exploit suchmistakes. Over time he willbe able to measure hissuccess or failure bycomparing his portfolio’sperformance to that of thebuy-and-holdstrategy.

ALONG-ONLYSTRATEGYFORTHEAGGRESSIVE

CONTRARIANTRADER

Thebasicideaunderlyingthislong-only strategy for anaggressive contrarian issimplicity itself. Look for abearish information cascadeand assume an above-normalallocationtothestockmarketwhen one is spotted. Reducethisallocationtonormalorto

below-normal levels after themarket has advanced ahistorically typical amountfromthelowpointassociatedwith the bearish informationcascade.

Bearish informationcascadesinthecontextofbullmarkets tend to be shorter intime and associated withmore modest drops in theaverages than are bearishcascades the context of bear

markets.Totakeadvantageofthis,theaggressivecontrariantradermusthavesomewayofdistinguishing between bullmarkets and bear markets inthe averages. A mechanicalmethod for doing this usingchangesinthedirectionofthe200-day moving average oftheS&P500hasalreadybeendiscussed. Here is another,more sensitive mechanicalmethod for identifying bull

and bearmarkets.Watch therelationshipbetweentheS&P500 index and its 200-daymoving average. When theS&P 500 drops 5 percentbelow its moving averageafterabullmarketofnormalextent and duration, theaggressive contrarian can bepretty sure a bear market isunder way. If the averagemoves 5 percent above its200-daymovingaverageafter

a bear market of normalextent,onecanbeconfidentabull market is under way. Ishould point out here that Ithinkthatforbearmarkets ingeneral it is better to beconcerned only with theextentofthebearmarket(thepercentage drop from thepreceding bull market high),because the time duration ofbearmarketsvarieswildly.

Now for thedetails of this

long-only strategy: In a bullmarket the aggressivecontrarian trader wants to beon the lookout for bearishinformation cascades. Oftenthese will show up asnewspaper headlines aboutfalling stock prices.Sometimes one finds onlypage 1 stories, not headlines.Dependingonthetenorofthetimes,onemight findbearishmagazinestockmarketcovers

aswell. Onemust rememberthatbearishcascadesinabullmarket tend to be very brief,lastingamatterofdaysor atmostafewweeks.

But a bearish informationcascade is not by itselfenough evidence to justifyincreasing your stockmarketallocation. In addition, youwant to see the S&P 500closing below its 50-daymoving average (just add up

the past 50 daily closes anddivideby50—easytodoinaspreadsheet). The S&Pshouldalsoberelativelycloseto its rising 200-day movingaverage,saywithin1percentif above it or less than 5percent below it. Sometimesit is also helpful to comparetheextentoftherecentshort-term drop in the S&P to theextent of previous drops inthe context of the same bull

market,sincetheseshort-termdrops tend to be the samesize. If these additionalcriteriaaremet,thenitwillbetimetoincreasestockmarketallocation to above-normallevels.

Having increasedhis stockmarket allocation to abovenormal during a bullmarket,theaggressivecontrariannowis on the lookout for theopportunity to move the

allocation back to normallevels. (I don’t think there isever any justification formoving to below-normalallocations in a bullmarket.)Generally this will comewhen the S&P has advancedto a new bull market high.Hereitisoftenusefultolookat the percentage gainsmadein previous upswings in thesame bull market, for theyoften turn out to be

comparable. The time tomove stock marketallocations back to normallevels often comes when thecurrent upswing has equaledthe average percentage gainofpreviousupswings.

In a bear market thisapproachhastobemodifiedabit. The typical stockmarketallocation for the aggressivecontrarian is then a below-normal one.A below-normal

allocation can be temporarilyincreased during the bearmarket, but only in specialcircumstances.

First,abearishinformationcascade must be visible inyour media diary. It isimportanttonotethatbearishinformation cascades lastlonger in a bear market thanthey do in bull market. Onemustgive themarketenoughtime to drop from a short-

termhightoanewlowpointfor the bear market toreinforce the bearish state ofaffairsininvestors’minds.AsaruleIwanttoseeadropofabouttwomonthsindurationin the S&P to new bearmarket lows before I act onany indication of a bearishcascade. Then, if the S&P isalso trading at least 10percent below its 200-daymoving average, it is

generally time to increasestock market exposure. Totimethesubsequentreductionin stock market exposure,watch the 50-day movingaverage of the S&P. Whenthe S&P moves 1 percentabove its 50-day movingaverage, it is time to returnyour stock market allocationtobelow-normalortonormallevels.

Of course, like all

strategies that objectively tryto distinguish between bulland bear markets, this onewill always be late. In otherwords, it will identify a bullmarket only after the low oftheprecedingbearmarkethasoccurred, and a bear marketonly after the high of thepreceding bull market hasoccurred.Missingthestartofabearmarketisgenerallynottoo much of a problem,

becauseinmostbearmarketstheworstpercentagedeclinesdevelop toward the end. Butmissing the start of a bullmarket can be a veryexpensivemistake.Itisintheearly stages of a new bullmarket that the buy-and-holdstrategy makes its biggestpercentage gains, and theaggressive contrarian tradergenerally does not want towaitforthebullmarketsignal

from the 200-day movingaverage before adopting abullmarketpolicy.

I handle this dilemma byusing my tabulations of theduration and extent ofpreceding bear markets andbypayingcarefulattentiontothe relative intensity ofbearish information cascadesduring bear markets. If themost intense bearish cascade(asmeasured by the number,

frequency, and semioticcontent of media stories)occursafterabearmarkethasdropped the averages atypical amount, I am willingtobet that thebearmarket iscompleteandthatthenextuplegwill be the first of anewbull market. Once I have anabove-normal stock marketallocation because think thatthe first leg of a new bullmarket is under way, I then

wait for theS&P to rally forat least six months and 25percent from its bear marketlow. At that juncture I startwatching the 50-day movingaverage. As soon as it drops0.5percentfromahighpoint,I reduce my above-averageallocation back to normallevels.

The novelty and power ofthis aggressive stock marketstrategy arise from

coordinating bearishinformationcascadeswiththeposition of the S&P 500relative to the appropriatemoving averages. Historicaltabulations of previousmarket swings play animportantrole,too,especiallyneartheendofbearmarkets.

MORE

AGGRESSIVECONTRARIANTRADING

STRATEGIES

This is the realm of theexpert, experiencedcontrarian trader.The ideas Iam about to discuss can bevery dangerous to yourfinancial health unless you

alreadyhave severalyearsofexperience with contrarianmethods and have been ableto beat the marketsignificantlyduringthattime.

First, onemay apply thesecontrarianmethodstosmallermarkets.Itisoftenpossibletotake advantage of marketcrowdsthatforminbonds,incommodity markets (crudeoil, gold, silver, soybeans,etc.), or in individual stocks

or industry groups. Theproblemonefaceshereisthatthese markets generallyattract much less publicinterest than does the stockmarket as a whole.Consequently, it is moredifficult to observe thecommunication process andthe information cascade thatbuilds the associatedinvestmentcrowd.Doingthisoftenrequiresparticipationin

industry associations,subscriptions to special-interest publications,attendance at investment andindustry-sponsored seminarsandevents,andthelike.Thismakesmuchgreaterdemandsupon a contrarian trader’stimeandcommitment.

Even so, there are verysignificant contrarianopportunities open in thesemarket segments.The reason

forthisistheadventofETFsintended to replicate theperformance of thesemarkets. These instrumentsmake it possible for theexperienced contrarian traderto take advantage of swingsin interest rates, commoditymarkets,and individualstockmarket sectors (e.g., finance,housing, banks, technology)efficiently, with low tradingcosts and good

diversification. Therefore,trying to identify maturemarket crowds in thesemarketscanbewellworththetimeandeffortrequired.

Here is another idea, adifferent twist on the usualcontrariantradingapproach.Ilike to call this thebandwagon strategy. Bullishmarketcrowdsgenerally takeat leastayear,ormoreoftenseveral years, to develop and

mature. This contrasts withthe typical bearish crowd,whoselifetimeismeasuredinmonths.Sincebullishcrowdstake so long to develop, thecontrarian trader can oftenbeat the market by detectingthe communication processthat is building the bullishcrowd soon after it starts.Atthis juncture the market isprobablystilltradingnearfairvalue. The bullish crowd is

still far from being mature.The trick at this point is tojoin the bullish crowdtemporarily by adopting thecrowd’s investment themeand buying the asset thatattracts the crowd’s interest.By doing this the contrariantrader is trying to participatein a market move that willbringthepricefromfairvalueup into the rarefied air ofextremeovervaluation.These

bull markets in individualsectors, stocks, orcommoditiesoftenshowgreatpercentage gains over fairvalue and can make a verysignificant contribution to acontrariantrader’sinvestmentresults.

Itgoeswithout saying thatthis bandwagon strategy canbe dangerous.The contrariantrader might forget hismethods and become a

permanent member of thechosen investment crowd. Ifhe allows this to happen, hisinvestment portfolio willsuffer for it, and this is whyonlyanexpertshouldattemptthissortofstrategy.

So far I have said nothingabout methods for takingadvantage of thedisintegration of a bullishmarket crowd and theaccompanyingbigdropinthe

price of the associated asset.Thereisagoodreasonformyreticencehere,becausetakingthe short side of anymarket,eithershortingstocksdirectlyorbybuyinganinverseETF,is a dangerous tactic.Bullishmarket crowds tend to lastlonger,arehardertoidentify,andmaycarrypricestolevelsof overvaluation that no onecanimagine.IntheU.S.stockmarket, indeed in the stock

market of any free-marketeconomy, the long-run oddsalways favor the bulls. Forthese reasons taking thebearish side by buying aninverse ETF, for instance,means bucking the long-runodds, which favor the bulls.Doing this successfullyrequires a very high level ofskill and market knowledge.Moreover, a long-shortstrategytypicallyyieldsmuch

more volatile investmentresults than does a long-onlystrategy. Even whengenerallypositive,investmentreturnsthatjumparoundalotput agreatdealof emotionalstressonaninvestor,andthisusually leads to baddecisions. It isnotsomethingI recommend to the novicecontrariantrader.

CHAPTER12

TheGreatBullMarketof1982-2000

Gloom in 1982 •amazing stock marketgains during the next18 years • the 1987

crash • bull marketcrowd before thecrash • ContrarianRebalancing duringthe 1987 crash • thesame strategy duringthe1929-1932crash •the savings and loancrisis • the 1990bearmarketcrowd•I’monCNBC • theconservativecontrarian increases

his stock marketallocation • no joyduring a big rally •the bubble starts toinflate • irrationalexuberance in 1996 •the conservativecontrarian stays withstocks for four moreyears • theaggressivecontrarian during thebull market • 1987revisited • my

experience during thecrash • bullish at the1990 low • the 1998collapseofLongTermCapitalManagement•bearish informationcascade • theaggressive contrariangoes long • thebubble’sgrandfinale

PROLOGUE

During the summer days ofAugust 1982, stock marketprospects appeared gloomy.Three years earlier, in itsAugust 13, 1979, issue,BusinessWeek magazinepublished its “The Death ofEquities” cover story. Now

BusinessWeek seemedprescient. Stock prices werenearly 10 percent lower inAugust 1982 than they hadbeen at the time of theBusinessWeek cover story.Nooneimaginedthenthatthegreatestbullmarketinhistorywas about to begin. OnAugust12 theDowclosedat776.92. That same day theS&P 500 index closed at102.42. During the

subsequent 17 and a halfyears theDowwould rise anastounding average of 16.42percent annually until itreached its towering highcloseat11,722.98onJanuary14,2000.TheS&Pwoulddoeven better, advancing anaverageof16.63percenteachyear until it reached its highclose of 1,527.46 on March24,2000.

But these two averages

were tortoises compared tothe hare of the NASDAQComposite index. On Fridaythe 13th inAugust 1982 thisindex closed at 159. OnMarch 10, 2000, it stood at5,048. The NASDAQ hadgained an unprecedentedaverage of 21.73 percentannually over a period ofalmost 18 years to reach itsbubble top in the newmillennium.

This chapter chroniclesmostofthisgreatbullmarketfrom the perspective of thecontrariantrader.Wepickuptheactionin1987atthetimeof that year’s stock marketcrash.Our story of this greatstock market bubbleculminates during the 19-month period from August1998 through March 2000,which saw the index of thebubble stocks, theNASDAQ

Composite, rocket up 235percentfrom1,499to5,408.

Stock market bubblesoccur perhaps once every 30years on average.During thetwentieth century we sawpeaksofminorbubblesintheU.S. stock market in 1906and 1973. Major bubblesdeveloped in 1929 and1999.Bubbles like these willhappen again. We mightexpect the next one around

the year 2030 if it developson schedule. It seems that ageneration must pass and itsmistakes be forgotten beforethe seeds of another stockmarketbubblecanbesown.

THE1987CRASH

Among the more dramaticevents of the 1982-2000 bull

market was themarket crashof 1987. On October 19 ofthat year both the Dow andthe S&P 500 fell about 20percent, a one-day dropgreater than any other in thehistory of the U.S. stockmarket. This panic declinewasthebiggestpartofaverybriefbearmarket.IntheS&P500 (the index I recommendforusebycontrarian traders)the 1987 top occurred at

336.77onAugust25and theclosing low at 223.92 onDecember 4, a drop of 34percent. In the Dow thecorresponding numbers are ahigh of 2,722 on August 25and a low of 1,739 onOctober 19, a drop of 36percent.

Investorswereveryfearfulafter the crash, and thisshowed in the newspaperheadlines and magazine

covers at the time. In itsOctober 20 edition the NewYork Times headlined in big,bold, black letters: “StocksPlunge508Points,aDropof22.6%; 604 Million VolumeNearlyDoublesRecord;WhoGetsHurt?” In itsNovember2 edition (on the newsstandsOctober 26) Time magazinepublishedanall-textcover inblack and white on a redbackground, the colors of

fear.Theheadlineread:“TheCrash:AfteraWildWeekonWall Street the World IsDifferent.” Of course, theworld really hadn’t changedat all; only investors’perceptionsofithadchanged.Newsweek magazine chimedin with the cover of itsNovember2issue.Itdepicteda line chart in red showing adrop in prices and an insetphotograph of worried

investors. It was headlined:“AftertheCrash.”

In this headline and thesecovers we see the bearishinformationcascadetriggeredby the crash itself and thesearch for the explanation ofsuch an extraordinary one-day drop. There was analmost instantaneous changein sentiment, and a bearishstock market crowddeveloped quickly. Such a

rapid and dramatic shift insentiment over only a fewdays is a very unusualphenomenon. How would aconservativecontrariantraderemploying the ContrarianRebalancing strategyrespondedtothecrash?

In mid-1987 there seemedlittle doubt that a substantialbullish stock market crowdhad developed during thepreceding three years. I had

just begun keeping a mediadairy that year, and thedocumentary evidence itcontainspointing toabullishinformation cascade issketchy. But I do rememberthat five years of steadilyrising prices had lifted thegloom that had prevailed inAugust 1982. By August1987 the dividend yields ofthe Dow and the S&P haddropped to historically low

levels. Price-earnings ratioson the averages were above20, at the time a historicallyhighlevel(butonethatwouldbe spectacularly exceeded 13years later). Marketcommentators publiclyworried about a possiblestockmarketbubble.

Duringtheearlierstagesofthe 1982-1987 advance theContrarian Rebalancingstrategy called for an above-

normal stock marketallocation.Butonce theS&P500 reached the 250 level in1986andhadrisen65percentfromitsJuly1984lowat148,the conservative contrariantraderwouldhavereducedhisstock market exposure tonormal levels because thebull market had entered azone of potentialovervaluation based onhistorical tabulations. Once

he observed the generallybullish commentary in themediaduring the firsthalfof1987andthehistoricallyhighprice-earnings ratio and lowdividendyieldontheS&P,hewould have concluded that abullish stock market crowdhad formed.At that point hewould be looking for a dropof 1 percent in the 200-daymoving average of the S&P500 as a signal to reduce his

stock market exposure tobelow-normallevels.

The 200-day movingaverage turned down by 1percent from its high byNovember 20, 1987, whenthe S&P itself closed at 242.This occurred after theintraday bearmarket low forthis average, which occurredon October 20 at the 216level. The conservativecontrarian trader would have

by then noted the bearishinformation cascade citedearlier. Moreover, at theOctoberlowtheaverageshaddropped about 35 percentfromtheir1987highs,adropofnormalextentwhenabullmarket crowd disintegrates.WhattodoonNovember20?

The answer is simple.Follow the rules of theContrarian Rebalancingstrategy!Eventhoughasteep,

35 percent drop had alreadyoccurredandabearishcrowdwas visible, the fact that the200 daymoving average hadturned downward by 1percent meant that the stockmarket allocation had to bereduced to below-normallevels.Butrememberthatthisis done only because bullishcrowd was visible at theprecedingstockmarkettop.Ifno bullish crowd had been

visible, the ContrarianRebalancing strategy wouldhave dictated that a normalstock market allocation bemaintained during anysubsequentdrop.

Having reduced his stockmarket exposure to below-normallevelsattheS&P242levelonNovember20,1987,what would be theconservative contrariantrader’s next move? He had

observedadropofatleast20percent in theaveragesandabearish stock market crowd.The Contrarian Rebalancingstrategythenrequiresamoveto an above-normal stockmarket allocation once the200-day moving averageturns up by 1 percent. Thishappened on September 9,1988,withtheS&Pclosingat267 that day.On that part ofhis portfolio representing the

difference between a normaland below-normal stockmarket allocation, theconservativecontrariantraderfell behind buy-and-holdinvestors during that nine-and-a-half-month period byabout 10 percentage points(or1,000basispoints).

INTERLUDE:THE

1929-1932CRASHANDBEARMARKET

The inexperienced contrarianisprobablyalreadybeginningtodoubt theefficiencyof theContrarian Rebalancingstrategy.Afterall,didn’tbuy-and-hold investors do betterduring the 1987 crash? Yes,

they did. But any marketstrategymustbejudgedonitsperformance over the years,notbyitsperformanceduringanyonemarketepisode.

There is an even moreimportant point to be madehere. The ContrarianRebalancing strategy is verycautious in moving to anabove-average stock marketallocationonceabearmarkethas begun. There is good

reason for this. Sometimes amarketcrisisdevelopsintoaneconomic crisis as well. Insuch circumstances one findsasequenceofdistinctbearishinformation cascades, eachleading to progressivelylower lows in the stockmarket and potentiallydropping the averages a verysubstantialamount fromtheirhighs.Theclassicexampleofthis phenomenon occurred

after the Crash of 1929.During the 1929-1932 bearmarket the Dow JonesIndustrial Average fell from381 to 40, a 90 percent dropover 34 months. There wererepeatedburstsofpessimism,each triggered by new signsof a deteriorating economicsituation: record highunemployment,bankfailures,and so on. This sequence ofbearish information cascades

began in late 1930 when theDowwas still above the 200level and continued throughthe bank holiday of March1933.

This was a situation whenthe tactic of using the 200-day moving average as anindicator would havedramatically improvedperformance relative to thebuy-and-hold strategy. In1929 the 200-day moving

averageoftheDowhadfallen1 percent from its high byOctober 28 when the Dowclosedat261.A reduction instock market exposure tobelow-normallevelswasthenwarranted. This movingaverage continued to dropsteadily for more than threeyears afterward. It finallyturned upward by 1 percentfrom its low on March 31,1933, about two weeks after

the end of the 1933 bankholiday.OnMarch31, 1933,the Dow closed at 55. Thenand only then would theconservativecontrariantraderhavebeenjustifiedinmovinghis below-normal stockmarket exposure to above-normallevels.

THES&LCRISIS,

THE1987-1990BULLMARKET,ANDTHE1990BEARMARKET

CROWD

A number of legislativechanges during the 1980slengthened the list ofpermissible real estateinvestments by savings and

loan (S&L) associations andcommercial banks. Thesechangesalsomadeiteasiertofinance loan portfolios bypaying higher yields on awidervarietyofdeposits.Theresultwasaboom in lendingon commercial real estate.Sadly, many of the resultingloans were unsound orfraudulentandtheseledtothecollapseofmanysavingsandloans and commercial banks.

The situation became sodangerous to the economy’shealththatinAugust1989theU.S. Congress passed theFinancialInstitutionsReform,Recovery, and EnforcementAct of 1989. One of itsprovisions established theResolutionTrustCorporation,which was to purchase andthen dispose of failed thriftinstitutions taken over byregulators after January 1,

1989.

The continuing stream ofS&L and bank collapsesduring 1988-1990 was abackdropthatdiscouragedthedevelopment a bullish stockmarket crowd. Memories ofthe1987crashwerestrongaswell, and these also put adamperonbullishsentiment.

The conservativecontrarian trader who

followed the ContrarianRebalancing strategy wouldhave assumed an above-normal stock marketallocation on September 9,1988, when the S&P 500closed at 267. In July 1990the S&P had reached 368.95while the Dow hit 2,964,gains of 65 percent and 71percent respectively fromtheir crash low points in1987. Since more than two

years had passed since thoselows, the conservativecontrarian would then havereduced his stock marketexposure to normal levels.Since no bullish informationcascadewasyetvisibleinhismediadiary,hewouldnotbecontemplating any furtherreduction in stock marketexposureeven if the200-daymoving average of the S&P500 were to subsequently

declineby1percent.

On August 3, 1990, theworldawoketothenewsthatIraqhad invadedKuwait andwas massing troops on theborderwithSaudiArabia,thesourceofmuchoftheworld’scrude oil supply. The stockmarket averages had alreadybegun to drop in late July,and thisnewsaccelerated thedecline. The first stockmarket headline appeared in

the New York Times onAugust 24: “U.S. StocksPlungeonHeavySellingoverCrisis in Gulf.” By then theS&P had already dropped to307.06fromitshighcloseof369.95,adeclineofnearly17percent.Thiswasn’tquitethe20percentminimumdropfora bear market, but the latterpercentage was reached onthenoseonOctober11,1990,when the S&P closed at

295.46, its bear market lowclose.

During the period betweenAugust and October themedia were worrying aboutpossible war in the Gulf andits economic and humanconsequences.Morethanthis,therewere additionalworriesaboutrisingunemployment,apossiblerecessionbroughtonby the real estate bust, and aFederal Reserve policy of

restraint intended to bringdown uncomfortably highinflation rates of over 6percent.

Evidence for this bearishinformation cascade was nothard to find in magazinecover stories. First up wasBusinessWeek, which askedonthecoverofitsAugust13issue: “Are We inRecession?”ThecoveroftheOctober1issueofNewsweek

featured: “The Real EstateBUST.”TheOctober15issueofTimemagazine, appearingjustdaysbeforethelowinthestock market, showed aphotographofamanhangingfromaclockhandhighabovea busy city street. The covercaption read: “High Anxiety—Looming Recession,Government Paralysis, andtheThreatofWarAreGivingAmericans a Case of the

Jitters.” Not to be outdone,the New Republic’s October29 issue showed a cartoonpicturing an abyss andcaptioned: “Oil prices aredoubling. Foreigners don’twant to lend us any moremoney.Therealestatemarketis in the toilet. The bankingsystem is tottering. Risingunemployment andstagflationarejustaroundthecorner. And the government

can’tthinkofadamnthingtodoaboutit.Uh,oh.”Bringingup the rear was New Yorkmagazine. Its November 19issue showed on its cover a1930s-era photograph of ayoungmandressedinathree-piece suit and shouldering aboxofappleswithasignthatsaid: “Unemployed—buyapples—5 cents each.” Thecovercaption?“HardTimes.”

Even a novice contrarian

would have recognized thisbearish information cascade.By mid-October a verybearish stock market crowdhad formed. It wasuniversally believed that warwith Iraq would send thestockmarketmuchlower,andthat the banking crisiswouldnotberesolvedanytimesoon.

At that time I made anumber of televisionappearanceson the thenvery

young financial network,CNBC. I was relentlesslybullishaboutthestockmarketandaboutthebondmarketineveryTV interview I gave. IpredictedthattheS&Pwouldrise from its295 low toover400 over the next couple ofyears. I also predicted thatlong-term bond yields woulddropfromthe9percent levelthen to 6 percent during thesame time frame. Both

predictions were on themoney.Iofferedanumberoftechnical reasons for theseviews, but my confidence inthem arose from myrecognition of the depth ofthe prevailing bearishsentimentand the strengthoftheconvictionsofthebearishmarket crowd. Mine was avery lonely market stance.The CNBC staff referred tome as “the bullish market

technician” to distinguishmefromtheirotherguests!

Through all these eventsthe Contrarian Rebalancingstrategy dictated holding anormal stock marketallocation.Sincetheaverageshaddropped20percent fromhigh to low and since a veryobvious bearish stockmarketcrowd had formed, theconservative contrarianwould be looking for a turn

upward in the 200-daymoving average of the S&Pto tell him to increase hisstock market allocation. OnMarch26,1991, thismovingaverage did turn up by 1percent from its low point.OnthatdaytheS&Pclosedat376 and the conservativecontrarian trader would haveincreased his stock marketallocation to above-normallevels. Notice that he would

have increased his stockmarket exposure at a pointthatwas actually a new highlevelfortheadvanceinpricesthat began in 1982. Nomatter. The conservativecontrarianisnottryingtobuynearthelowandsellnearthehigh.Hisonlyobjective is tobeat the buy-and-holdstrategy.

RALLYWITHOUTJOY,1991-1994

FromitsOctober1990lowat295 the S&P 500 indexadvanced steadily for morethan threeyears. It reachedatemporary high point at 482on February 2, 1994. Thisrepresentedanadvanceof63percent from its 1990 lowover a period of 40 months.

Overthesameperiodoftimethe Dow advanced 68percent. The ContrarianRebalancing strategydictateda reduction of stock marketexposure from above-normalto normal levels at this timebecause the bull market hadmet normal expectations fordurationandextent.

A contrarian trader mustalways be contemplating hisnext move in every

circumstance. In February1994, with a normal stockmarket allocation goingforward,hehastoknowhowhewillactshouldthe200-daymoving average of the S&Pdrop1percentfromanyhighlevel it attained during thebull market. The onlycircumstance in which thisevent calls for a reduction instock market exposure is thepresence of a bullish stock

market crowd created by abullishinformationcascadeinthemedia.Hadsuchabullishcrowd developed by early1994?

My own media diary forthe period shows that nobullish information cascadehad even started by early1994.Thisiseasilyseenfroma sampling of magazinecoversfrom1991to1993.

TheOctober7,1991,issueofBusinessWeek hada covercartoon of a man thinking:“I’mWorriedaboutMyJob!”On November 4 Newsweekchimed in with a covercartoon showing a familyinsidethejawsofaferocious-looking wolf. The covercaption read: “WhatRecovery? The Bite on theMiddle Class.” Inside themagazine the lead story was

headlined: “That SinkingFeeling—the recession thatwon’t go away has averageAmericans spooked—andpoliticians running scared.”On December 2BusinessWeek published a“HighAnxiety”headline thatemphasized concerns aboutan elusive economicrecovery. The November 29issueoftheEconomisthadonits cover a cartoon depicting

stock traders tumbling downagraphoffallingstockpricesworldwide.Thecaptionread:“Andtheyallcried,‘Help.’”Finally, the December 23issue of the New Republicwas done with a completelyblackbackgroundwithapairof cartoon eyes peeringupwardfromthebottomofaneconomic recovery. Thecaption read: “What’s reallywrong with our economy—

andhowtofixit.”Thiswasaremarkable gaggle ofpessimistic economic coverstories within a short three-month span. It was proofpositive that no bullishinformation cascade hadbegunbytheendof1991.

Not to be outdone, Timemagazine chimed in with adepression cover for itsJanuary 13, 1992, issue. Itshowed a black-and-white,

Depression-eraphotographofa businessman buying anapple from an unemployedstreetvendor—exceptthatthevendor’s imagewas replacedby a 1992 color image of amaninabaseballcapholdingan apple. The cover captionread:“HowBadIsIt?”

AsIwritetheseparagraphsI find it jarring to recall thatthe 1990-1991 recession hadalready officially ended in

March 1991, seven monthsbeforethissequenceofcoverstories appeared. The U.S.unemployment rate was stillrising, however, and wouldreachahighof7.8percentinJune 1992. To put this intohistorical perspective, thehighest post-World War IIunemployment rate was 10.8percent,reachedinDecember1982. The highest recordedunemploymentrateduringthe

Great Depression of the1930s was 25 percent. Twopointsareworthmakinghere.First,itishighlyunlikelythatany bullish informationcascade will develop in thestock market whileunemployment rates arerisingduringarecessionoritsimmediateaftermath.Second,inthisparticularcaseonegetsthe impression from thesemagazinecoversthattheU.S.

economywasonthevergeofcollapse into Depression-eraconditions.Thisillustratesthetendency of the media toexaggerate economic news,especially the worrisomekind, a tendency that helpsstart information cascades ofone kind or the other. Thistendency seems especiallypronounced when thepresidentoftheUnitedStateshappens to belong to the

Republicanparty.

This intense pace ofpessimistic cover storiesslowed significantly in 1992but did not halt entirely.TheOctober24,1992,issueoftheEconomist showed a paintingof shipwrecked sailorsclinging to a rock in theocean and was captioned:“Recession or Doom?”Remarkably, barely fourmonths later and following

the election of President BillClinton, a Democrat, thesame magazine showed acover cartoon of a joyfulUncleSamspringingupfromhis hospital bed, on whichhung a chart of an upturn ineconomic activity.The covercaptionread:“NoNeedforaBoost.”

The magazine coverindicator was quiet for therestof1993.However,aftera

bearish information cascadethatfairlycanbesaidtohavelasted nearly three years, thecontrariantradercouldrightlysurmise that it would take atleast a year and probablyseveral before bullish animalspirits could revive and oncemore manifest themselves inthe stock market. For thisreason I think theconservativecontrariantraderwould have chosen to ignore

any drop in the 200-daymoving average of the S&Pin 1994. In the event, thismoving average did turndown but not by the full 1percent required by theContrarian Rebalancingstrategy, so the issue wasmootinanycase.

THESTOCK

MARKETBUBBLEINFLATES,1995-

2000

Theveryfirstconvincingsignthat a bullish informationcascade had begun appearedonthecoveroftheNovember13, 1995, edition of U.S.News & World Report. Thecover caption read: “Gold

Rush in Cyberspace—TheInternet Will ChangeEverything—And EveryoneWantsaPieceoftheAction.”The boom in Internet-relatedstocks had begun, but, asusuallyhappens,noonecouldimagine the heights ofovervaluation that thesebubble stocks would reach.Note that this cover shouldhaveattractedtheattentionofaggressive contrarian traders

because it was evidence thatthe internet stockbandwagonhad started rolling.Bandwagon investors in thisand related sectors did verywell during the subsequentfiveyears.

On June 3, 1996,BusinessWeek took note ofthestockmarketupsurgewithacovercaptioned:“OurLoveAffair with Stocks—Neverbefore have so many people

had so much riding on themarket. Should we worry?”The September 30, 1996,cover of Time magazineshowed a photographofNedJohnson, head of the mutualfund complex FidelityInvestments. Johnson isdepicted holding a globecovered by ticker symbols.Thecovercaptionread:“CanFidelity Still Make YourMoneyGrow?”

This Time cover wasdefinitive evidence that abullish stock market crowdhad formed. It demonstratedthat the public mind wasfocused on the stockmarket,because Time is a generalinterest newsweekly. But thecriticalthingeverycontrarianmust remember is that it isvery difficult to predict justhow big any bullish crowdwill eventually grow. In this

particular case the crowdcontinued to grow until theendof1999,afullthreeyearsafter the appearance of thisTime cover.The fact that theBusinessWeek cover asked“Should we worry?”suggested to me that thebullish crowd would growstillbiggeruntilworrywasnolonger associated with thestockmarket.

Recall that the Contrarian

Rebalancing strategy calledfor the conservativecontrariantradertoreducehisstock market allocation tonormal levels in early 1994.From that point forward hemaintained that normalallocation. Even after he hadrecognizedthisTimecoverasstrong evidence of a maturebullishinvestmentcrowd,thecontrarian trader wouldcontinue holding a normal

stock market allocation. Anyreduction in stock marketexposurewouldhavetoawaita turn downward in the 200-day moving average of theS&P by 1 percent or more.When the Time cover cameout, the S&P stood at 686.But the moving average sellsignal did not occur untilJanuary 2, 2001, more thanfouryearslater.Onthesignalday theS&Pclosedat1,283,

87percenthigherthanonthedatewhen that 1996 issue ofTimehitthenewsstands.

There was naturally muchmore evidence of thisenormousbullish informationcascade as it proceededthrough 1997, 1998, and1999. For one thing, stockmarket valuations asmeasuredbydividendyields,price-earnings ratios, andTobin’s q ratiowere literally

off the chart. Even moretelling were the frequentarticles in the financial pressexplaining why traditionalvaluation measures were nolonger useful in this new erabullmarket.Thesamekindofrationalizations appear tojustify out-of-sight stockprices near the top of everyextended boom and arealways a sign of an inflatedbubble and a mature stock

marketcrowd.

Another interesting signofthe times could be found atyourlocalbookstore.Insharpcontrast to the situation in1982, books about the stockmarket had become popularand were being publishedweekly. They occupiedmoreand more retail shelf space.Especiallypopularwerethosebooks that married computertechnology to stock market

trading. Typical were threebooks reviewed byChristopherByronintheJune28,1999, editionof theWallStreet Journal. Their titles:Day Trade Online, How toGetStartedinElectronicDayTrading, and Electronic DayTraders’Secrets.

The definitive history ofthe remarkable 1982-2000bull market has yet to bewritten. As I mentioned in

Chapter 5, I recommend thatevery contrarian trader readBull!byMaggieMahar.Thisbook, published in 2004 byHarperCollins,doesafinejobof recounting the history oftheboomandbustfrom1982through2002.

The conservativecontrarian trader didreasonably well during thehistoric advance of 1987-2000. He certainly beat buy-

and-hold investors bymaintaining an above-normalstock market allocationduringmostofthe1991-1994advance. At that point hisallocation reverted to normaland he continued holding anormal allocation untilJanuary2,2001.While theseare not spectacular results,oneshouldkeep inmind thatthe 1987-2000 period wasone during which the buy-

and-hold strategyoutperformed virtually everyother imaginable portfoliostrategy. Even worse, manyself-styled contrarians hurtthemselves badly byremaining out of the stockmarket from 1996 or 1997onward. Indeed, those whoheededRobert Shiller’s 1996warning (conveyed to thepublic by Alan Greenspan,chairman of the Federal

Reserve) about the then-visible irrational exuberanceof the stock market vastlyunderperformedbuy-and-holdinvestors from that pointforward. Itwascertainly truethatin1996thatstockmarketvalues were historically highand that a bullish stockmarket crowd had formed.But it isequally important toremember that bubbles caninflatemuch further thancan

be imagined by reasonablepeople. Our ContrarianRebalancing strategy’s 200-daymoving average tactic isdesigned to take this fact offinancial life inabubble intoaccount.

THEAGGRESSIVECONTRARIANFACESTHE1987

CRASH

IntherestofthischapterIamgoing to illustrate the use ofthe aggressive contrarianstock market strategy,described in Chapter 11, atthree dramatic juncturesduring the 1987-2000 bullmarket.Thisrecountingofanaggressive contrarian’sactions during this 14-year

bull market is therefore farfrom exhaustive. Thecomplete story would takemore pages to tell thananyone would want to read.I’ll be content to convey theessence of an aggressivecontrarian’s market approachby describing only a few ofthe more important portfolioadjustments made by theaggressive contrarian traderduringthistime.

Asexplainedearlierinthischapter, the contrarian traderhad every reason to believethat a bullish stock marketcrowd had formed by thesummer of 1987. The stockmarket averageswere clearlyovervalued by historicalstandards of dividend yieldand price-earnings ratios.Sentimentwasoptimisticandbullish, largely because theaverages had risen

substantially since 1982. Forexample, from August 1982through June 1, 1987, theS&P 500 had risen about 24percentperyear.

In March 1987, with theS&Ptradingalittlebelowthe300level,Idecidedtoreducesubstantially my portfolioallocationtothestockmarket.At the time I wasmeasuringthe S&P’s progress from itsJuly 1984 low at 148. By

mid-1986 the average hadadvanced 65 percent fromthat low over a period ofabouttwoyears.Thismettheminimum standard forpotential marketovervaluation. However, in1986 I did not yet seeconvincing evidence of abullish stock marketinformation cascade.Moreover, at the time Ithoughtthattheadvancefrom

the 1982 lows would takeabout five years beforesignificant levels ofovervaluation could bereached. So I maintained anaggressively bullish stanceuntil March of the followingyear.

Note that inMarch 1987 Ireducedmy own exposure tothe stock market to wellbelownormallevels,atacticIdo not recommend even to

the aggressive contrariantrader. But I was confidentthat even if the S&P movedsubstantially higher I wouldget a chance to increase mystock market exposure toabove-normal levelswithin afewmonths.Intheevent, thehigh close for the S&P was337, reached on August 25,1987.

OnFriday,October16,theS&P closed at 282, a level 5

percent below its 200-daymoving average and a signalto the aggressive contrariantrader that abearmarkethadstarted. No bearishinformation cascade wasvisible at the time, so theaggressive contrarian wouldwant to reduce his stockmarket exposure to below-normal levels on this signal.Why?Abullishstockmarketcrowd had clearly formed by

the summer of 1987. Whensuch crowds disintegrate, theaverages typically drop aminimumof30percent fromtheir highs and sometimesmore. Such a prospectjustifies having only aminimalexposuretothestockmarket.

The next trading day,October 19, 1987, the majoraverages dropped anastounding 20 percent. The

S&Pclosedthatdayat225.Iremember the following dayasacompletelychaoticoneinthe markets. Around middayon the 20th, there waseffectively a trading halt onthe New York StockExchange. There were nobids for stocks!Thiswas thetime of maximum panic. Iestimate that theS&Phad infactfallento190orsoamidstthis chaos, although the low

forthedayofficiallyrecordedin market statistics was 216.(The S&P futures traded aslowas181on the20th.)Butthen, as if out of nowhere,buyersappearedandafuriousrally started. During thesubsequent week the S&Pfluctuatedwildlyinthe216to258 range. Bid-ask spreadsfor stocks and futures wereenormous, reflecting thewidespread shock and fear

thecrashhadgenerated.

The bearish informationcascade that developed inresponse to the crash wascertainly visible a weekafterwardonOctober26.TheS&P closed that day at 227,more than 24 percent belowits 200-day moving average.By all rights this was thedefinitive indication for theaggressive contrarian traderto increase his stock market

exposure to above-normallevels.

Did I do so?No! Iwas asshell-shocked as everyoneelseatthetime.IknewthatattheOctober19-20lowpointsthe averages had fallenmorethan 30 percent from theirhigh points. I knew that thiswas a typical bear marketdrop associated with theunraveling of a bullish stockmarket crowd. But the time

element just didn’t seem tofit. It usually takes manymonths for a bullish crowdsuch as the one evidentduringthesummerof1987tounravel,butonlytwomonthshad passed since the August25 top.SoIchose then tositonmyhands,donothing,andawaitevents.

I waited until May 1988,about nine months from thedateoftheAugust1987top.I

estimated that this was theminimum duration of a bearmarket associated with thedisintegration of a bullishstock market crowd. But inMaytheS&Pdroppedonlyaslowas248,alevelwellaboveits low of the previousOctober. It was then that Idecided that theOctober lowprobably ended the bearmarket.Ifthiswastrue,Ihadto increase my stock market

allocation to above-normallevels. This I did. Since thehypothesis I adopted inMay1988 was that a bull marketwas under way, I wanted tofollow the special ruleappropriateforthefirstlegupin a bullmarket.One shouldwaitforanadvanceofatleast25 percent from the lowclose,whichtakesatleastsixmonths. Then start watchingthe 50-day moving average.

Cut stock market exposureback to normal levels whenthis 50-day moving averagedrops0.5percentfromahighpoint.

A 25 percent advance onthe bearmarket low close of224 on December 4, 1987,would carry the S&P up to280. This level was firstreachedonOctober20,1988,10 months later. From thelatterdatethe50-daymoving

average continued toadvance. Its firsthalfpercentdrop became visible onNovember6,1989,when theS&Pclosed at 332.Thiswasthe point at which theaggressive contrarian traderwould cut his above-normalallocationtothestockmarketbacktonormallevels.

THE1990LOW

Earlier in this chapter Iexplained how a bearishinformation cascadedeveloped during the lastquarterof1990inresponsetotheS&Lcrisis and the threatofwarintheGulf.OnAugust21,1990,theS&P500closedat 322, more than 5 percentbelow its 200-day movingaverage. At that juncture theaggressive contrarian traderwould have moved to a

below-normal stock marketallocation.

A bearish informationcascade would have beenveryevidentbymid-October,which was also a time whenthe S&P spent several daysmore than 10 percent belowits 200-day moving average.It would have been easy forthe aggressive contrariantrader to move to an above-normal stock market

allocationata timewhen theS&P was trading below the305level.

The1990bearmarketwasbrief, carried the S&P downby 20 percent, and ended atthe 295 level onOctober 11.AtthetimeIwasverybullishand believed that a new bullmarket had started. Ireiterated this in several TVappearances on CNBC thatfall.During the first leg of a

bull market the aggressivecontrarian wants to maintainan above-average stockmarket allocation for at leastsix months, awaiting anadvancefromthebearmarketlow point of at least 25percent. Sixmonths after theOctober 1990 low the S&Pclosed at 378, more than 27percentabove that lowpoint.At this juncture theaggressive contrarian trader

would start watching for thefirstdropof0.5percentintheS&P’s 50-day movingaverage, the signal to reducehisstockmarketallocationtonormal levels.ThishappenedonJuly5,1991,withtheS&Pat374.

LONGTERMCAPITAL

MANAGEMENTGOESBUST

Wenextfast-forwardto1998.Itwas a dramatic year in theworld’sfinancialmarkets.OnAugust 17 the Russiangovernment defaulted on itsforeign debts. The ruble felldramatically against othercurrencies. The global bondmarket was thrown into

turmoil by the Russianfinancial crisis, and thiscausedenormous losses foravery big hedge fund, LongTerm Capital Management.Thefund’slossesweresobigthat they threatened thesolvency of several WallStreet banks.Because of thisso-called systemic risk, theFederal Reserve orchestrateda buyout of the fund’sportfolio by a consortium of

these same banks. Not onlythat, the Fed cut ratessubstantially and added agreat deal of liquidity to themoneymarketstopreventthepanicfromspreading.

The first sign of a bearishinformation cascade was theNew York Times headline onthe August 28, 1998, whichread: “Markets Jolted, DowOff 4.1% as the RussianEconomic Slide Adds to

Pressures on Yeltsin.” OnSeptember1,mylocalpaper,theMorristownDailyRecord,headlined: “Dow Wipeout—Gains for year lost in 512-pointplunge.”

The bearish informationcascade was also prominentin weekly newsmagazines.On the cover of itsAugust 8issuetheEconomistshowedacartoon of a bear wearingsunglasses in which was

reflected a chart of fallingstock prices. The captionread: “Grin and Bear It.” Amonth later, in itsSeptember14 issue, Time magazine’scover asked: “Is the BoomOver?” and showed a graphof falling stock prices downwhich tumbled investors. Onthe cover of its October 12issueNewsweek asked: “TheCrash of ’99?—It doesn’thave to happen but here’s

whyitmight.”

Prior to theRussian crisis,theS&Phadreacheditshighclose at 1,187 on July 17,1998. It would fall to a lowclose of 957 on August 31andanintradaylowof923onOctober8.Thiswasadropofnearly20percentonaclosingbasis, more on an intradaybasis. Events moved soswiftly that the aggressivecontrarian trader would not

have been able to sidestepany of this decline. In fact,the first day on which theS&Pclosedatleast5percentbelow its 200-day movingaverage was also the day ofthelowclose,957onAugust31. That was the firstopportunity the aggressivecontrarian could have takento reduce his stock marketexposure to below-normallevels.

The S&P first closed atleast 10 percent below its200-day moving average onthe day of its intraday low,October 8. A bearishinformation cascade wasclearly under way by then.The aggressive contrarianwould have increased hisstock market allocation toabove-normal levels at the959levelintheS&P.

At this juncture I was

willing tobet thatanewbullmarket was beginning. Thiswas a gamble because it hadbeenevidentsince1996thatasubstantialbullmarketcrowdhad developed. Since theS&P had dropped only 20percent from its highs, therewas every reason to thinkbased on historical precedentthat a bigger price declinewould develop and carry theaverage down 30 percent or

more.

Rememberthatthefirstlegof a new bull marketgenerally sees the biggestpercentagegainsoftheentireadvance.Ididn’twanttotakethechanceofmissing it.Theaggressive contrarian, havingguessed that a new bullmarketwasunderway,wouldwanttowaitforsixmonthstopassafterthebearmarketlowand for the S&P to rise at

least 25 percent from thatlow. Once these two criteriaweremet,hewouldwatchforahalfpercentdropinthe50-daymovingaveragetosignala reduction in stock marketexposure.

I decided to adopt acompromise policy thatwould protectme if a biggerdeclinewas at hand. Iwouldstick with my above-normalstock market allocation until

the 50-day moving averageturned downward by 0.5percent. If this happened, Iwouldmovebacktoabelow-normal allocation even if sixmonths had not passed andthe market had not risen 25percent.

In theevent, it tookonlyalittle more than two monthsfor the S&P to move aboveitsJuly17highandatnotimedid the 50-day moving

averagedrop0.5percentfromahighduringthatrally.Oncenew highs were attained, Iadopted the six-month, 25percent rule appropriate forthe first legofabullmarket.A move back down to anormal stock marketallocationwas triggered by ahalf percent drop in the 50-day moving average onSeptember20,1999,withtheS&P closing at 1,336. The

bull market that started fromthe 1998 low would not enduntilthefollowingMarchatahigh close of 1,527 in theS&P.

CHAPTER13

CollapseoftheBubble:The2000-2002BearMarket

Endofthebubblebullmarket • the

conservativecontrarian stays untilthe lights go out •bear market signal inJanuary 2001 • howfar down? • bearishinformation cascadeafterthe9/11terroristattack • a long waitfor a signal • thebears party in July2002 • an amateurcontrarian fades the

crowd • theconservativecontrarian waits untilJune 2003 • theaggressive contrariantradesthebearmarket•Wall Street wreck •Newsweek predicts abear market • mythinking during thesummerrallyafterthetop•October11bearmarket signal • a

chance to buy inMarch 2001 • outagain in April •trading after 9/11 •buying near the bearmarket low • the firstleg up in a new bullmarket

ENDOFTHEGREATBULL

MARKET

The greatest bull market inthe history of the UnitedStates began from the lowsestablished in theDowJonesIndustrial Average and theS&P 500 index in August1982.OnAugust12theDowclosedat776.92andtheS&Pat102.42.Anastounding18-year advance culminated on

January14,2000,intheDowwhen it closed at 11,722.98.The S&P reached its bullmarket peak on March 24,2000, at 1,527.46. The homeof the bubble stocks, theNASDAQ Composite index,movedupfrom159inAugust1982toahighcloseof5,048onMarch10,2000.

How would the contrariantrader have been positionedastheseaverageswereending

this record-breaking bullmarket in early 2000? Keepin mind that the biggestmistake any contrarian tradercan make is to beunderinvested for anysubstantial period of time inan extended bull market.Beating the market meansoutperforming the buy-and-holdstrategy,anditisduringlong bull markets that thisstrategyshines.Soevenafter

the contrarian trader hadidentifiedthebubblecrowdinlate1996hewouldonlyhavemaintained his stock marketexposure at normal levels.Amove to below-normalexposurefor theconservativecontrarian following theContrarian Rebalancingstrategy would await aturndown in the 200-daymoving average of the S&P500by1percentfromitsbull

market high. The aggressivecontrarianwouldwaittoseeadrop in the S&P 500 of 5percent below its 200-daymoving average. Thesetacticswouldhelpboth typesof contrarian trader remaininvested in the bubble bullmarket as long as wasprudent.

CONTRARIAN

REBALANCINGDURINGTHE2000-

2002BEARMARKET

The200-daymovingaverageof the S&P 500 reached apeak of 1,447.54 on October5, 2000, and had fallen 1percent from that level byJanuary 2, 2001. On January

2theS&Pclosedat1,283.Atthis juncture theconservativecontrarian trader would havehad ample reason to reducethe allocation to the stockmarket in his portfolio tobelow-normal levels. In ourrunning example wherenormal is a 60 percentallocation, a below-normalallocation would perhaps be30percentorevenless.

Iwanttoemphasizeherea

very important point: Thecontrarian trader isemphatically not in thebusiness of picking tops andbottoms in the stock marketaverages. Insteadhe is in thebusinessofoutperformingthebuy-and-hold investmentpolicy. Doing this does notrequire getting out of stocksclose to the tops of bullmarkets and getting back innearthelowsofbearmarkets.

Rather it requires thecontrarian trader to leanagainst the crowd, to investopposite the preferences ofwell-established marketcrowds by identifying thepointwhere thesecrowdsareliable tobegindisintegrating.It isveryhard to identify thetop of a bull market, butmuch easier to see when abullish crowd is about todisintegrate after such a top

hasprobablydeveloped.

THELONGWAYDOWNAGAIN

Themostimportantfeatureofthe 2000-2002 bear marketfrom the contrarian trader’sstandpoint was that itdeveloped from the collapseofastockmarketbubble.The

bubble had developed duringthe last years of the 1990s.The information cascade inthe media that built thebubble’s stock market crowdwas easy to identify. By anyhistorical standard the stockmarket was grotesquelyovervaluedatitshighpointintheyear2000.

Stock market bubbles donot develop very often, butwhen they do the ensuing

bear market is likely to belong and severe. This bearmarketwasnoexception.Bythe time it ended in October2002, the Dow had dropped39percent, theS&P500haddropped 50 percent, and theNASDAQ Composite nearly80 percent from their highpoints in early 2000.Depending onwhich averageis used as ameasuring stick,the bear market lasted

between 31 and 33 months.Historically, the lastcomparable drop in extentand duration was the GreatCrash during 1929-1932,which ushered in the GreatDepressionofthe1930s.

The contrarian traderknows that the postbubblebear market is likely to belong and severe. For theconservative contrarian whois employing the Contrarian

Rebalancingstrategy,thishasimportant implications. First,he knows that a severe bearmarket will probably lastanywhere from18months tothree years. He expects themarket to drop at least 30percent and probably closerto50percentduringthistime.Hewantstotakeadvantageofthese historical tabulationsand the information in hismedia diary to assume an

above-normal stock marketallocation as soon as isprudent—that is, as soon asheseesevidencethatthebearmarkethasended.

Let’s see how these goalscould have been achievedduring the 2000-2002 bearmarket.

CONTRARIAN

REBALANCINGDURINGTHE

CRASH

InChapter11Iexplainedthata conservative contrariantrader should increase hisstock market allocation toabove-normal levels once hehas evidence that a bearmarket is complete. This

requires three conditions tobemet.First,hemustdetectabearish information cascadeinhismediadiary, a cascadeintense enough to build asubstantial bearish stockmarket crowd. Second, theS&P 500 should havedroppedasmuchasistypicalfor the type of bear marketthatisunderway.Soifitisabear market attending thecollapse of a bullish stock

market crowd (associatedwith some sort of bubble),then he would expect a dropin the S&P of 30 percent ormore. Otherwise, a normalbear market would drop theindex only 20 to 30 percent.Finally, the 200-day movingaverageoftheS&P500mustturn upward by 1 percentfrom whatever low it madewhen thefirst twoconditionsweresatisfied.Oncethisthird

condition is met, theconservative contrarianincreases his stock marketallocation to above-normallevels.

Since the biggest stockmarketbubbleinU.S.historywasassociatedwith the2000high point in the marketaverages, the conservativecontrarian trader wouldexpect the subsequent bearmarket to drop the S&P at

least 30 percent. Once thishappens, he determineswhetherthereisevidenceofabearishstockmarketcrowdinhis media diary. The highclose in the S&P was 1,527on March 24, 2000. A 30percent drop from 1,527would bring the averagedownto1,069.OnSeptember17, 2001, the S&P closed at1,038,itsfirstclosebelowthe30percentmark.Wastherea

bearish information cascadeunder way at the time?Wasthere a bearish stock marketcrowdvisible?

My answer to both thesequestions is yes, but forreasonsthatareabitunusual.The World Trade Center inNewYorkCitywas attackedbyterroristsonSeptember11,2001. The stock market wasclosed for a week afterwardand reopened on September

17. The S&P had beendropping steadily for almostfour months from a short-term high point it made onMay 21, 2001, at the 1,313level. The impact of theterroristblowonthefinancialmarketswasenormous,butitwas not recorded onnewspaper front pages or onmagazine covers for obviousreasons. Instead it waspolitical and military news

that dominated the media.Even so, page 1 of theNewYork Times business sectionon September 12, 2001, washeadlined: “The FinancialWorld Is Left Reeling byAttack.” The September 21edition of the ChicagoTribune had a page 1 stockmarket story, complete withcharts showing drops in allthe averages during thepreceding week. It was

headlined: “America’sPsycheTakesAnotherBlow,Old Assumptions No LongerApply; ‘There Is Fear in theMarketplace.’” The previousday the S&P had closed at984.SoIthinkitisfairtosaythat the conservativecontrarian trader would havebeen justified in concludingthat a bearish informationcascade was under way. Hewould then await a move

upward of 1 percent in the200-day moving average oftheS&P500.

This would have been along and trying wait, for thedesired 1 percent upturn inthe 200-day moving averagedidnotdevelopuntilJune13,2003, when the S&P itselfclosed at 988. There werefireworks in the marketplacein the meantime. The S&Pmoved as high as 1,178 in

January 2002 and as low as768laterinOctoberthatsameyear. These fluctuationsoccurredagainstthebackdropof a second bearishinformation cascade, whichdevelopedduringthesummerof2002.

Thefirstsolidevidenceforthis second bearishinformationcascadeappearedin the July 13, 2002, editionof theNew York Times. This

was a page 1 stock marketstory,althoughitwasnot theday’s headline story. Thestoryappearedabovethefoldand was accompanied bybearish charts of the S&P500, the federal budgetdeficit, and plungingconsumer confidence levels.The story’s headline read:“Bears on Prowl As MarketEnds a Dreary Week.” Thefollowing day saw another

above-the-fold, page 1 stockmarket story, again not theday’sheadline.Thestorywasheaded: “Stocks’ Slide IsPlaying Havoc with OlderAmericans’Dreams.”Finally,on July 17 the stock marketmade it into the Times’sheadlines:“FedChiefBlamesCorporate Greed; HouseRevises Bill—GreenspanCites Cause for InvestorWoes—Dow Drops Again.”

MoreevidencecamefromtheTimes’s July 20 page 1headline: “Market ContinuesFour-Month Rout; DowPlunges390.”ThatsamedaytheChicago Tribune chimedin with this headline: “DowDives to Four-Year Low.”And on July 23 the Tribuneheadlined: “Dow Slidesbelow8,000to’98Level.”

My wife, an amateurcontrarian trader, increased

her stock market allocationon July 22, 2002, the firstmarketdayafterthetwoJuly20headlinestories.TheS&Pclosed on July 22 at the 820level, her trade price sinceshewasinvestinginS&P500indexfunds.Mywifeactedasan aggressive contrarianwould, but when would aconservative contrarianassume an above-normalstock market allocation?

Certainly the market hadfallen far enough, almost 50percent as measured by theS&P,todeflatetheprecedingbubble. There was aprolonged bearishinformation cascade, whichhad built a powerful bearmarket crowd. All that wasnecessary to trigger anallocation increase would beaturnupwardby1percentinthe 200-day moving average

of the S&P 500. Thishappened on June 13, 2003,when the S&P 500 closed at989.Onthatdaythe200-daymoving average of the S&Preached 887.96, a 1 percentmoveupfromitsbearmarketlow point of 879.03 reachedonMay1,2003.

So we see that theconservativecontrariantraderwouldhavereducedhisstockmarket allocation to below

normal on January 2, 2001,with the S&P at 1,283. Hethen would have moved hisallocation toabovenormalatS&P 988 on June 13, 2003.Notice two important things:He did not go to a below-normal allocation until theS&P had already dropped asubstantial amount from itshigh close at 1,527. And hedid not restore his allocationtonormaland then toabove-

normal levels anywhere nearthe low bearmarket close of777. This illustrates a veryimportant point: It is notnecessary to sellnear the topor to buy near the bottom toimprove one’s investmentperformance relative to thebenchmark buy-and-holdstrategy.All that isneededisto buy at levels that are onaverage significantly lowerthan the levels at which you

sell.

THEAGGRESSIVECONTRARIAN

DURINGTHE2000-2002BEARMARKET

The 2000-2002 bear marketyears were punctuated by

three very substantial ralliesthat carried the S&P up atleast 20 percent. There weremany wonderfulopportunities for theaggressive contrarian traderto buy into these three bigralliesandtosellorevensellshort in anticipation of thesubsequent declines.However, in this chapter Iwill pass over the shortselling opportunities open to

the aggressive contrariantrader during this postbubblebullmarket.Why?

I think that trading on theshortsideofthestockmarket,even via inverse exchange-traded funds (ETFs), is agame that should be playedonly by experts. It requiresgreatflexibilityofmindandacompletely unbiased view ofmarket opportunities. Thesecharacteristics are not well

developed in a novicecontrarian trader. Expertsdon’t need my help, but Iwanttourgebeginnersnottogettoofaroutovertheirskis.The stock market is atreacherous realm for anyinvestor, and beginners arewell advised to focus on theoneactivitythatisfavoredbya secular uptrend in theU.S.stock market: buying andselling long positions. So in

therestofthischapterIpointoutsomeoftheopportunitiesthat were open to anaggressive contrarian traderwho was content to manageonlylongpositionsduringthe2000-2002bearmarket.

AWALLSTREETWRECK

The S&P 500 established itsclosing high for the bubblebull market on March 24,2000, at the 1,527 level.Naturallynocontrariantraderwould have known then that1,527was destined to be thebullmarket’s high close.Buteverycontrariantraderwouldhave seen plenty of evidenceof extreme overvaluation inthe stock market. And everycontrarian trader’s media

diary would have containedplenty of evidence of thebullish information cascadethat had created the bullishbubble crowd in the stockmarket. So, at the very least,everycontrariantraderwouldhaveadoptedawaryviewofthe market and would havebeenalertforsignsthatabearmarkethadbegun.

In March 2000 I believedthat despite these warning

signs the bull market hadfurther to run.My reasoningwas based on my historicalmarket tabulations. I thoughtthat a mini-bear market hadended inOctober1998at theintraday 923 low in theS&P500.FromthereIthoughtthata normal bull market wouldevolve, one that according tomy tabulations would lastabouttwoyearsandcarrythemarketupabout65percentor

perhaps a little more. A 65percentadvancefromthe923levelwasachievedonMarch23, 2000, when the S&Pclosedat1,527.But the two-year guideline would not beachieved until October 2000.So I expected the ultimatemarkettoptooccursometimeduring the September-October2000timeframe.

During bull markets theaggressive contrarian trader

should always reduce hisstock market allocation tonormal levels once the S&Phasralliedat least15percentfrom some short-term lowand has made a new bullmarket high. In March 2000the aggressive contrariantrader might have gottenlucky and reduced his stockmarket exposure to normallevels very nearwhat provedto be the ultimate top.Why?

There had been a short-termlow on February 25, 2000,with the S&P closing at1,333,about2percentbelowits 200-day moving average.Thatshort-termlowhadbeenaccompanied by a briefbearish information cascade,which was highlighted by apage 1 story in the February26 edition of the New YorkTimes.Thestorywasheaded:“Stocks in Turmoil as

Worries Grow on HigherRates—Dow Closes below10,000.” If an aggressivecontrarian had taken anabove-normal stock marketallocation near the February25 low close, hewould havereturned to a normalallocation after a 15 percentadvance in the S&P (the1,533 level, which wasreached intraday on March24, but never reached on a

closingbasis).

As mentioned, there wasno way to know at the timethat the March 24 close at1,527 would be the bullmarket top. It is for thisreason that I don’trecommend going to below-normal stock marketallocations during a bullmarket, even if you are anaggressive contrarian.Instead, the right policy for

an aggressive contrariantrader in an ongoing bullmarket is to await anopportunity to increase stockmarket exposure to above-normal levels. As wasillustrated in the case of theFebruary25lowat1,333,thiswould require a drop in theS&P500toorslightlybelowits rising 200-day movingaverage at a time when ashort-run bearish information

cascade was under way. Atthat point the aggressivecontrarian can assume anabove-normal stock marketallocation even though heknows full well that a bearmarket might begin at anytime. The reason for this isthat it is impossible to guessjust how far a stock marketbubblemightinflate,anditisusually best for even theaggressive contrarian trader

not to implement a bearmarket strategy until he seestheS&Pdrop5percentbelowits 200-day moving average,an event that did not occuruntilOctoberofthatyear.

A short-run bearishinformation cascadedeveloped quickly after theMarchtop,inApril2000.Themarket averages, especiallythe NASDAQ Composite ofbubble stocks, dropped

sharply from their Marchhigh points. On April 5, theNewYorkTimesheadlinedonpage 1: “Nasdaq Recoversafter a Free Fall in a WaryMarket.” This headline storywas accompanied by a colorphoto of a floor traderlooking distressed asbackground to a graphshowing the NASDAQComposite’s gyrations thepreviousday.Atthecloseon

April 4 the S&P stood at1,494, a full 8 percent aboveits 200-day moving average.Moreover, ithaddropped forless than twoweeks from itsMarch top and the drop hadcarried it down only about 2percentonaclosingbasis.Sowhile it appeared that abearish information cascademay have begun on April 5,the market had not droppednear its 200-day moving

average,norhaditdropped5to10percentforaboutonetothree months from its high,thesebeingtheparametersfornormalbullmarket reactions.So an aggressive contrariantrader would still be waitingfor a better opportunitybefore increasing his long-side exposure to the stockmarket.

Things started to fall intoplace on April 13. The New

York Times printed a page 1stock market story, not theheadlinebut appearingabovethefold.Thestory’sheadlineread:“InOnlyaFewWeeks,Nasdaq Falls 25.3% from ItsPinnacle—Steep DropSuggests a Technology BearMarket.” Then, on Saturday,April15, theTimes printed amulticolumn,boldprint,page1 headline: “StockMarket inSteep Drop As Worried

Investors Flee; Nasdaq HasIts Worst Week.” The localMorristownDailyRecordhadasitsheadlinethatday:“WallStreetWreck.”

Clearly a short-run bearishinformation cascade hadtaken hold and built up ashort-lived bearish crowd,one typicalofshort-termlowpoints in a bull market.Moreover, on April 14 theS&P500hadclosedat1,357,

2 percent below its rising200-day moving average,below its 50-day movingaverage, and nearly 12percent below its March topat1,527.Thiscombinationofcircumstances made this anideal buy spot for anaggressivecontrariantrader,aplacewhere itmade sense torestore his stock marketallocation to normal or evento above-normal levels. As

far as anyone could tell, thebullmarketwasstillaliveandwell.

There is amagazine coverthat appeared in April 2000thatmeritstheattentionofanaspiringcontrariantrader.Onthe cover of its April 24,2000, issue, Newsweekmagazine showed aphotograph of a glass ofwater in which two antacidtablets were dissolving. The

cover caption read: “Is theBull Market Really Over?”This is an example of aneerily prescient magazinecover. Such covers are veryunusual but do appearsometimes,anditisimportantforthecontrariantradernottobe misled by them. A naivecontrarian would be temptedto respond to the cover’squestionbyguessing that thebull market was not over.

And he would have beenwrong!Thepointhereis thatthecoverwastrumpedbytheclear and overwhelmingevidence that a stock marketbubble had already formed.And historical experiencesuggested that it would takemonthsandprobablyyearstodeflate.

THESUMMER

RALLY

The low close for the S&P500 in April 2000 occurredon April 14 at 1,356. As Ihave pointed out, there wasample reason for theaggressive contrarian traderto move to an above-normalstock market allocationduring the short-run bearishinformation cascade that

developed that month. Butthere was no reason for himto believe that the bearmarket associated with thedisintegration of the bullishbubble crowdhadyet begun.The bull market that startedfrom the October 1998 lowhadrunonly17months,wellshort of the average of 20 to24 months. True, it hadcarriedtheS&Pup65percentat the March 2000 top. But

the contrarian is alwaysacutely aware that stockmarketbubblescaninflatefarbeyondwhat is suggested byany historically basedstatisticalprojection.Soatthevery least the aggressivecontrarian traderwouldawaita drop of 5 percent in theS&P below its 200-daymoving average beforeswitching over to a bearmarkettradingstrategy.Inthe

meantimehisproblemwastodecide when to reduce hisabove-normal allocation tonormallevels.

Here ishowIhandled thisproblem at the time. As Ipointed out earlier in thischapter, I thought the bullmarket that started from theOctober 1998 low wouldcontinue into the September-October 2000 time frame.Atthat point I expected that the

bubblecrowdwouldbegintodisintegrateandabearmarketwould takehold. I alsoknewthe following importantcharacteristic of the 1998-2000 bull market. There hadbeentwoshort-termreactionsprior to the one thatdeveloped during March-April 2000. After each ofthese two reactions hadended, the S&P 500 workedits way to a new high bull

market close within sixweeks.Thus Idecided tousethissix-weektimeintervalasa measuring stick to gaugethestrengthof the rally fromtheAprillows.

On June 19 the S&Preachedanewclosinghighof1,486 for the rally from theApril low. Eight weeks hadpassed, but the average stillhad not managed to moveabove its 1,527high closeof

March 24, 2000. This I tookasawarningsignthatthebullmarket topmayalreadyhavebeen seen. But it was only awarning. I resolved to moveinto bear market mode if Isawadailyclose in theS&Pthatwasmore than1percentbelow its 200-day movingaverage. Such a close wouldoccur while the 200-daymoving average was stillrising, but I believed that an

aggressively bearish stancewould be warranted since itwas clear that an enormousbullishcrowdhadformedandthattheidealtimeframeforatop, September-October2000, was rapidlyapproaching.

OnSeptember1,2000,theS&P500reachedarallyhighof 1,521, close to but stillbelow its bull market highcloseof1,527.OnSeptember

26 the S&P closed at 1,427,morethan1percentbelowits200-day moving average,whichthenstoodat1,447andwas still rising. At thatjuncture I assumed a bearmarket posture for mycontrarian trading. As amatter of fact, I had alreadyreduced my above-normalstock market exposure tonormal levels in July as themarket rallied, this because

more than six weeks hadpassed since the April lowwithout a new bull markethigh. In late September Ireduced my stock marketexposure still further, tosubstantially below-normallevels. This was a moreaggressive approach than Irecommended in Chapter 11,but then I have a lot moreexperience than a typicalcontrarian.

What would a typicalaggressive contrarian havedone had he reduced hisallocationtonormallevelsbyusing the same tacticemployedearlier thatyearontherallyfromtheFebruary25low?Thebullmarkettopwasalreadyinplace,andtheS&Pnever rallied as much as 15percentfromitsApril14low.Aswas discussed in Chapter11,onewayforanaggressive

contrarian to identify a newbearmarket is towatch foramove in theS&P thatcarriesit5percentbelowits200-daymoving average after anormal bear market. OnOctober 11, 2000, the S&Pfirstdropped5percentbelowits 200-day moving average,closing at 1,365. At hisjuncture the aggressivecontrarian trader wouldassumeabelow-normalstock

market allocation. Inparticular he would sellwhatever he had boughtpreviously near the April2000lowpoint,probablyatasmallloss.

THEMARCH2001PLUNGE

Beginning on October 11,

2000,withtheS&Pat1,365,the aggressive contrarianwouldhavehadamplereasonto think a bear market wasunder way. Since there wasplenty of evidence that astock market bubble hadformedduringthe1994-2000stock market advance, thereasonable expectation wasthat this bear market woulddrop the averages at least 30percent from their March

highpoints.

On March 12, 2001, theS&P 500 dropped below the1,200 level to close at 1,180,its lowest level inmore thantwo years. The NASDAQCompositeaveragedropped6percent that day, bringing itstotal decline from its March2000 top at 5,048 to 61percent. Clearly the bubblehad popped. The March 13edition of the New York

Times headlined: “MarketsPlunge in Wide Sell-Off;NasdaqFalls 6%.”Abearishinformation cascade hadbegun, and the aggressivecontrarian trader wouldimmediately check theposition of the S&P relativeto its 200-day movingaverage. At its close onMarch 12 the S&P stoodalmost 16 percent below thatmoving average and thus

justified increasing stockmarket exposure, providedthat there was a well-developed bearishinformation cascade inprogress and that the markethad been falling for twomonthsormore since its lastshort-term top (which in thiscase had occurred in lateJanuary). Had the cascadethen gone far enough toindicate the presence of at

least a short-term bearishcrowd? My own answer tothat question was that it hadnot. This was only the veryfirstheadlineofadevelopingcascade. Moreover, themarkethadbeendroppingforlessthantwomonthsafteritstop in late January. Asubstantial bear marketappeared to be under way,especially in the NASDAQCompositeindex.SoIwanted

toseemoreevidencethanjustasingleheadlineinmymediadiarybeforeconcluding therewas a bearish crowd bigenough to justify increasingmystockmarketallocation.

Such evidence was notlong in coming. The March26 issues of Time magazine,Newsweek, andU.S. News&Word Report all had bearishstock market covers. Theseissueswereonthenewsstand

about a week earlier thantheir publication dates. BothTime and U.S. News hadphotographs of growlingbears on the cover. TheNewsweekcoverasked:“HowScaredShouldYouBe?”Itisvery unusual, even in a bearmarket, to see three suchmagazine covers in the sameweek. I took this as solidevidence that a good-sizedbearish crowdhad developed

and that a short-term stockmarket lowwasathand.TheaveragepriceoftheS&P500during the 10 trading daysending March 26 was 1,153andrepresentsa fairestimateof the price at which anaggressive contrarian couldeasily have increased hisstock market exposure. Theactual short-term closing lowfor the S&P occurred onApril4at1,103.Theintraday

lowoccurredonMarch22atthe1,081level.

Noticethatthelowcloseof1,103 was not 30 percentbelow the March 2000 highclose of 1,527. The drop inthe S&P was not yet typicalof a bear marketaccompanying thedisintegration of a bubblecrowd. Such bear marketstypically drop the S&P atleast 30 percent and often

more. For this reason theaggressive contrarian wouldnot interpret any subsequentmoveintheS&Ptoapoint5percent above its 200-daymovingaverageasasignthatanewbullmarketwasunderway. In this particular casethis cautionary observationproved to be moot. In theevent, the S&P nevermovedabove its 200-day movingaverage until after it had

fallen more than 30 percentfrom its bubble high point at1,527.

Having increasedhis stockmarket exposure to above-normal levels in March, theaggressive contrarian traderwouldnextbe lookingforanopportunity to sell his newlyacquired long position andmove back down to below-normalexposure.Afterall,asfar as he could tell the bear

market was still in progressbecause the S&P had notdropped at least 30 percentfrom itsbullmarket top.Thebear market trading strategydescribed in Chapter 11 forthe aggressive contrariandictates that he wait for theaverage to move 1 percentabove its 50-day movingaverage. This happened onApril 18 when the S&Pclosedat1,238.

The interesting thingaboutApril 18 was that it was theday of a surprise rate cut bythe Federal Reserve. Since Iwatch themarketsduring theday, Iwasable to reducemystock market exposure aboutanhouraftertheFedmadeitsannouncement. This was anexample of fading bullishnews in a bear market if itgeneratesabigrally.Itmadegood sense at the time

because the news itself sentthe S&P 500 up almost 5percent within about 30minutes after theannouncement. I knew thatthemarketwouldbepushingabove its 50-day movingaverage.

TERRORISTSATTACKON9/11

With a below-average stockmarketallocation inplacebythe close on April 18, theaggressive contrarian traderwould again be looking foranother bearish informationcascade to develop when theS&P was trading at least 10percent below its 200-daymoving average after a droplasting at least two monthsfrom its last short-term highpoint. The price and time

parameters were met onSeptember 6, 2001, with theS&Pclosingat1,106.Buttheaverage had not yet droppedback below its March 2001low point, so it is notsurprising that no bearishinformationcascadewasthenevident.

TheterroristattackonNewYork City’s World TradeCenter on September 11changed the situation

dramatically, as I describedearlierinthischapter.Bearishsentiment becamewidespread. The aggressivecontrarian trader would haveeasily been able to increasehis stock market allocationwhile the S&P was tradingbelow 1,000. The averagereacheditsclosinglowat966on September 21 and itsintradaylowof945thatsameday.

Every trade requires a buyandaselltobecomplete.Theaggressive contrarian traderwho bought below the 1,000levelwouldbelookingfortheS&Ptomove1percentaboveits 50-day moving averagebefore again reducing hisstockmarket allocation. Thishappened on November 5,2001,whentheS&Pclosedat1,102. The rally from theSeptember lows eventually

carriedtheS&P500toahighclose of 1,173 on January 4,2002.

ENDOFABEARMARKET

During all of 2001 and 2002theS&P500never closed asmuch as 5 percent above its200-day moving average.

Indeed, formost of this timeit stayed below its movingaverage. The aggressivecontrarian trader never hadreason to doubt that a bearmarket was in progress.During this time his typicalstock market allocation wasat below-normal levels, buthe took advantage of bearishinformation cascades totemporarily increase stockmarket exposure.He last did

this in September 2001, butreturned to a below-normalallocationinearlyNovember.

ByJune21,2002,theS&Phadagaindropped10percentbelow its 200-day movingaverage. However, the S&Pstill had not dropped belowits September 21, 2001, low,so it was not surprising thatno bearish informationcascade was evident in mymedia diary at that date. By

mid-July, however, that lowhad been broken and abearish cascade was wellunder way. I explained thedetails earlier in this chapter.Theclosing low for theS&Pwas 798 on July 23. I thinkthe aggressive contrariantrader had plenty ofopportunity to increase hisstockmarket exposure belowthe 900 level that July. Forthe sake of discussion, let’s

suppose he did so at anaveragepriceof860.

This move to an above-normalallocationdidnotlastlong. The aggressivecontrarian trader would haveobserved the S&P close at951onAugust19,morethan1 percent above its 50-daymoving average. Since theS&Pwas still below its 200-day moving average, hewould then have reduced his

stock market exposure tobelow-normal levels at thattime.

During the entire July-October 2002 time frame theS&P500remainedatleast10percent below its 200-daymoving average. Thusanytime that the bearishcascadeagainbecamevisiblethe aggressive contrariantrader would be justified inonce more increasing his

stock market exposure afterhaving reduced it on August19. The only caveat I wouldadd is that he would alsowant to be sure that theaverage was within a fewpercentage points of its Julylowatthesametime.

As it happened, there wasnot much evidence for arenewed cascade when theS&P established its closinglow for the bear market on

October 9, 2002, at the 777level. My media diary isfilled with bearish newsstories thatwere prevalent atthe time, but there were noheadline stories evident.However, there were somepage1stories.TheOctober9edition of the ChicagoTribunehadapage1,above-the-fold news analysisheadlined: “Risk-ProneEconomyLimpsAlong.”The

analysiswasaccompaniedbygraphs showing thedownwardcourseoftheDowJonesIndustrialAverage.ThefollowingdaytheWallStreetJournal had a significantpage 1 story that was not aheadline story. It appearedabove the fold and wasaccompanied by chartsshowing dropping stockmarket prices. The storywasheaded:“BearsClawMarkets

Yet Again, As DowIndustrials Fall Nearly 3%.”At the time I underlined theopeningsentenceofthestory,which read: “A harsh air ofgloomhungoverthemarkets,sending investors fleeingstocksyetagain.”Thesecondparagraph began: “Whyhavethingsgottensobad?”

At the time I took thesetwo stories as evidence thatjustified an increase in stock

market allocation, largelybecause the intraday bearmarket lowonOctober10 at769 was a little below theintraday low reached on July24 at 776. A big bearishcrowd had been built upduring repeated bearishinformation cascades in theprevious two years.Moreover, the average haddropped nearly 50 percentfrom its March 2000 high

point over a period of 31months. Both parameterswere near the outer limitsreached by bear marketsduringthepast100years.

The S&P quickly movedback more than 1 percentabove its 50-day movingaverage onOctober 21whenit closed at 900. Since theS&Pwas still below its 200-day moving average, theaggressive contrarian trader

may then have chosen toreduce his stock marketexposure to below-normallevels. However, he wouldalsohavehadgoodreason tobelieve that the move off oftheOctoberlowpointwasthefirstlegofanewbullmarket.If so, following the methoddescribe in Chapter 11, hewould have ignored thisOctober 21 sell signal. Ipersonally did not adopt this

view until after the March2003 low had developed. Ineither case the investmentresults would have been thesame and are describedbelow.

From November 2002through January 2003 theS&P remained below itsdeclining 200-day movingaverage, but not by as muchas 10 percent. But onFebruary 7, 2003, the index

droppedmorethan10percentbelow its 200-day movingaverage. This excursionlasted only a few days andwas not accompanied by anybearish cascade. On March10,11,and12theS&Pagaintraded at least 10 percentbelow its 200-day movingaverage. This time war withIraq was imminent and wasthe focus of page 1 stories.The start of hostilities in a

warcangenerallybetakenasan indicator of bearishsentiment and of a bearishmarket crowd (see thediscussioninChapter9).TheoutbreakoftheIraqwarwiththeS&P10percentbelowitsmoving average justified anincrease in stock marketexposure by the aggressivecontrarian trader. On March11,2003,theS&Pestablishedits2003lowcloseat800.

TRANSITIONTOANEWBULLMARKET

Contrarian strategies, like allother trading strategies, facetheirgreatestchallengeat thepoints of transition betweenbull and bear markets. It isespecially important that acontrarian trader not be left

on the sidelines during theearly stagesofabullmarket,becausethatiswhenthestockmarket averages make theirbiggestpercentagegains.Theaggressive contrarian canrecognize a new bull marketbywatchingforthefirstclosein the S&P that is 5 percentabove its 200-day movingaverage. But this sort ofsignal always occurs wellafter the actual bear market

lowpoint.Consequentlythereisasignificantdangerthattheaggressive contrarian willreduceanabove-normalstockmarket allocation to below-normal levels just as themarket accelerates upward inabullmarket’searlystages.

Here is how I dealt withthis danger in 2003. First,stock market sentiment hadbeen very bearish for eightmonths. Indeed, in March

2003 the weekly survey ofinvestors conducted by theAmerican Association ofIndividual Investors showedhistorically high levels ofbearish sentiment. The bearmarket had carried the S&Pdown by nearly 50 percentand the NASDAQ down by80percent.Ithadlastedmorethan 30 months and thusexceeded the historical normin duration and extent. With

this as background, the factthat the market made aclosinglowinMarch2003at801, visibly above the levelofitsOctoberlowat777andin a situation when war wasimminent, made me suspectthat better timeswere ahead.So I decided to defer sellingmy increased stock marketallocationlongenoughtoseeif theS&Pcould tradeaboveits933highofNovember21.

If it did, then I would takethat as preliminary evidencethat a new bull market hadbegun and switch to a bullmarketstrategy.

In the event, the S&Prallied strongly as the Iraqwar began andmoved abovethe 933 high on May 6. OnMay2theS&Pclosedat930,morethan5percentaboveits200-day moving average. Atthat point every contrarian

trader would have hardevidence that a new bullmarkethadbegun.

CHAPTER14

ThePostbubbleBullMarketof2002-2007

Bears at the 2002-2003 low points • theconservativecontrarian increases

his stock marketexposure •30 monthslater he reverts to anormal stock marketexposure•lookingfora bullish informationcascade • Google’sIPO • the housingbubble • theaggressive contrarianduringthebullmarket• avoid below-normalstock market

allocations during abull market • May2004 buyingopportunity • March2005 buyingopportunity • tradingduring2006and2007

ESCAPINGTHEBEAR’SCLAW

Likeallbullmarkets, thebigadvance that began from theOctober 2002 low startedamidstconditionsof fearandlossofconfidenceintheU.S.economy. The stock marketspent nearly eight monthstradingsidewaysnearthelowpoints of the2000-2002bearmarket. The S&P 500 tradedas low as 771 in July 2002,thenaslowas768inOctober2002, and finally as low as

789inMarch2003.

During that eight-monthperiod, the bearish stockmarket crowd that hadformed during the bearishinformation cascade ofMay-October 2002 remainedstrong. Indeed, somepollsofinvestor sentiment showedthe maximum bearishsentiment at theMarch 2003lowpointwhichoccurredatahigherprice level inboth the

Dow Jones IndustrialAverage and the S&P 500index than the October 2002lows. For example, theweekly sentiment pollconducted by the AmericanAssociation of IndividualInvestors showed nearly 60percent of respondentsbearish during the week ofthe March 2003 low point.This was a greater bearishpercentage than was seen at

any time during the 2000-2002 bear market. This factconvinced me then that thebearish crowd was on thevergeofdisintegration.

By2007theDowandS&P500would double from their2002 lows at 7,181 and 768respectively. How would theconservativecontrariantraderhave positioned his portfolioto take advantage of thisadvance? In Chapter 13 we

saw that on January 2, 2001,the 200-day moving averageof the S&P had dropped 1percent from its bull markethigh. That day the S&Pclosed at 1,283 and theContrarian Rebalancingstrategycalledforareductionof stock market exposure tobelow-normal levels, thisbecause all the signs of abubblewere evident near the2000top.

During a bear market thatfollows a bubble, theconservative contrarianmaintains a below-normalstock market exposure. Heexpects to see a drop in theS&P 500 of at least 30percent.Oncesuchadrophasdeveloped, he looks for abearish information cascadetooccurnearapotentialbearmarket low point. If onedevelops and if the 200-day

moving average of the S&Psubsequently advances 1percentfromalowpoint, theconservative contrarian hashis signal to increase hisstock market allocation toabove-normallevels.

ByOctober 2002 the S&Phad fallen nearly 50 percent.The May-October bearishinformationcascadehadbuiltthe bear market crowd untilits views dominated in the

media. Then on June 13,2003, the 200-day movingaverageoftheS&Pturnedupby 1 percent. That day theS&P500 closed at 988.Thisupward turn in the 200-daymoving averagewas the firstto occur during the entire2001-2003 period. On thatday the conservativecontrarian would haveincreased his stock marketexposure to above-normal

levels.

The ContrarianRebalancingstrategycallsfora reduction of stock marketexposure to normal levelsonce the bull market hascontinuedfor20to24monthsandtheS&Phasadvanced65percent from its low point.The low close for the S&Pwas777onOctober9,2002.A65percentadvanceonthatlowwouldcarry the index to

1,282. On January 6, 2006,the S&P closed at 1,285, itsfirst close at or above 1,282,and had advanced for morethan three years. At thatjuncture the conservativecontrarian trader would havereduced his portfolioallocationtothestockmarkettonormallevels.

WHATBULL?

LOOKINGFORSIGNSOFABULLISH

INFORMATIONCASCADE

AsIhavealreadypointedout,the 2002-2007 postbubblebull market nearly doubledboth the Dow and the S&Pand lasted five years. One

normally would expect tofind an enthusiastic bullmarket crowd form in suchcircumstances. But thetrauma of the previous bearmarket, which had sent theS&P 50 percent lower andlasted nearly three years,apparently had very long-lasting effects on investors.Perhaps thiswas because thebubble stocks that led themarket to its top in 2000

suffered even more than theaverage stock in the S&P.The bubble stocks for themost partwere traded on theNASDAQ. The NASDAQComposite average dropped80 percent during the 2000-2002bearmarket!

For whatever reason, thesigns of a bullmarket crowdand a bullish informationcascadeneverappearedinmymediadiaryduring the2002-

2007bullmarket.Let’srecallthesigns.

First of all, magazinecovers that favorably (evenheroically) depict corporateleaders of prosperousindustries generally appearduring a bullish informationcascade. During this bullmarket I noticed only onesuch cover story, whichappeared in the October 24,2005, issue of Time

magazine. The cover was aphotograph of AppleComputer’s founder andCEO, Steve Jobs, and wascaptioned: “The Man WhoAlways Seems to KnowWhat’sNext.”

Another kind of bullishcover story conspicuous byits absence was onediscussing the “new” role ofmoney and wealth in ourculture and economic

environment. Typically thesetellthestoryofthenewlyrichentrepreneurs who havebecomewealthybyridingthetide of rising stock marketprices and spectacular initialpublicofferings(IPOs).

A second sign of a bullishinformation cascade is aseries of well-publicized andvery profitable (for thecorporate insiders at least)initialpublicofferings.These

were very prominent duringthe 1994-2000 bubble bullmarket but almost entirelyabsent during the 2002-2007bull market. The singleexceptionwasGoogle’s IPO,whichIwilldiscussshortly.

A third sign of a bullishinformation cascade is theemergence of one or morepied pipers—financialcommentators, marketstrategists, or industrial

leaders who are thought tohave predicted the bullmarket and are constantlybeingquotedinthepressandother media cheerleading forrising prices and predictingmore to come. Many suchgurus became prominentduring the1996-2000period,whichsawtheinflationofthepricesofmanybubblestocks.None were featured in themedia during the 2002-2007

bullmarket.

Afourthsignindicatingthepresence of a big bullishstock market crowd is ageneral sense of well-beingand optimism on the part ofthe public. This generallyshows up in opinion polls ofvariouskinds, inmeasuresofconsumer sentiment, and indiscussions found in themedia and in ordinary,everyday sorts of

conversations abouteconomic and stock marketprospects. Far from showingany signs of such optimism,public opinion during the2002-2007 bull market wasgenerally pessimistic aboutthe economy and theprospects for the UnitedStates. This may have beendue in large part to theprosecution of the Iraq warand the general concerns

about terrorism, but opinionsare what they are whatevertheirgenesis.

A final sign of a bullishinformation cascade is thevery well publicized bullishperformance of one or moreinnovative business sectorsand their common stocks.Duringthe1994-2000bubblebull market these were thecomputer, communicationstechnology, and Internet-

related sectors. During the2002-2007 bull market, thebest-performing stockmarketsectors were related tohousing and finance, butthese sectors did not attractnearly the public attentionthat the dot-com stocks haddone during the precedingbubblebullmarket.Indeed,itis likely that the onlysignificant bullish investmentcrowdof2002-2007occurred

notinthestockmarketbutinthehousingmarket.Thegreatadvance in home pricesduring the 1995-2005 periodcertainly created the beliefthat investment in owner-occupied housing was a sureroad towealth. Itwould turnout that the collapse of thishousing market investmentcrowd would have seriousconsequences in the stockmarketin2008,butthecrowd

itselfwas not a stockmarketcrowd. I’ll have more sayabout the investment crowdinthehousingmarketlater.

Since no bullish stockmarket crowd developedduring the 2002-2007advance, the conservativecontrarian trader should havemaintained his normal stockmarket allocation even aftertheaveragesstartedtodeclinefromtheirOctober2007high

points. In the event (seeChapter 15), this involvedsuffering through a drop inthe S&P of more than 50percent during the panic of2008.However,thereisgoodreason for adopting such astrategy, even when it canexpose the trader to suchrisks. The long-runinvestmentoddsintheUnitedStates favorowningcommonstocks. The Contrarian

Rebalancing strategy takesthese odds into account bybeing very careful beforeadopting a below-averageallocationtothestockmarket.

The most damagingmistake a contrarian tradercan make is to maintain abelow-average allocation tothe stock market during anextended period when thestock market averages areadvancing. This would

guarantee portfolio returnsinferiortothosegeneratedbythe buy-and-hold strategy.Therefore, the ContrarianRebalancing strategydemandsareductionofstockmarket exposure to below-normal levels only if thecontrarian trader seesconvincing, affirmativeindications of a bullish stockmarket crowd in his mediadiary.

THESTORYOFGOOGLE’SIPO

On August 18, 2004, thesearch engine companyGoogle conducted an initialpublic offering (IPO) of itscommon stock. This offeringwas unusual in two respects:It was conducted by GoogleitselfviaanunusualDutchorreverse auction, and this

auction was conductedonline. Google had hoped tosell 25.7 million shares in arangeof$108to$135,butinfactwasabletosellonly19.6million shares at $85.At thetime, Wall Street gloated atthe apparent disappointingoutcome of the auction. Ofcourse it was the Street’sinvestmentbankerswhoseoxwas gored by Google’sdecision to conduct the IPO

itself instead of giving theStreet’s underwriters asubstantialpieceofthepie.

But it was Main Street’sreaction to the prospect ofthis IPO and to the eventitself that I found moreinteresting and significant.Investorshadbeenburnedsobadly by the collapse of thedot-com bubble that theyseemed to actually hope thatGoogle’s IPO would fail.

They wanted the price ofGoogle’s newly issuedcommon stock to dropfollowing the offering. Suchhopes about a widelyanticipated IPO are highlyunusual.As a rule, there is abullish anticipation of theIPO of any company in thetechnology or computersector, especially one assuccessful as Google hadbeenindominatingtheonline

searchmarket.Investorshopeto make some quick profitson the IPO as it isoversubscribed. But bullishsentiment toward Google’sIPO was nowhere to befound.

Insteadthepublic’sattitudeseemed to be that investorswho bought Google’s IPOdeservedtolosemoney.Afterall, hadn’t everybody beenhurt by the big drop in the

prices of the bubble stocksduring the 2000-2002 bearmarket? The same thingwould happen again, andwould justify these investors’sour attitude toward thestocks of all tech andcommunication companiesand toward the stock marketingeneral.

InAugust2004Ifoundthispublic attitude toward theupcoming Google IPO

astounding.Itseemedthatthebull market that had startedfrom the 2002 lows had notyet entered a zone ofovervaluation, and neitherhad a bullish stock marketcrowd been evident from thematerial I preserved in mymedia diary.Googlewas theleading company in its field.The bull market was stillgoing strong, and it wouldtend to lift the price of

Google’sstockalongwiththegeneral market. Add theseconsiderationstotheevidenceofthepublic’shighlyunusualbearish hopes andexpectations about Google’soffering, and you have aclassic opportunity to fadethis bearish stock marketcrowd that formed aroundexpectations for Google’sstockperformance.

I told my friends and

clients at the time that forthese reasons Google was abuyatitsIPO.Afterthestockadvancedfrom$85 to$200Iwent out on a limb andpredictedamovetothe$500level before the bull marketended.Eventsprovedme tooconservative, for by the endof October 2007Google hadrisen to$747.The2008bearmarket dropped Google to alow price of $247, but this

wasstillnearlythreetimesitsIPOpriceof$85.

The day after Google’sIPO the public’s attitudecouldbeseenreflectedintheNewYorkTimesandtheWallStreetJournal.

On page 1 of the Times’sAugust19editiontherewasastory headlined: “WeakDemand Leads Google toLower Its Sights.” The story

was accompanied by a colorphoto of the news ticker inTimes Square, which read:“Google Slashes PriceRange.” The story’s leadsentence read: “Google,concedingthatdemandforitslong-awaited public stockoffering had fallen far shortof the company’s hopes,slashed the number of sharesyesterday and concluded itsunorthodoxonlineauctionby

accepting a price well belowitsoriginaltarget.”

The August 19 edition ofthe Wall Street Journal hadtwoGoogle stories. The firstwas headlined: “Is Now theTime to Buy Google?” Itssubhead: “Though Price IsNow Lower, HistorySuggestsWaitingSixMonthstoGrabanIPO.”(Sixmonthslater Google’s stock wastrading at $190.) A second

storyinthatday’sWallStreetJournalsaidevenmoreaboutthe public’s attitude. Thestory’s headline was: “HowMiscalculations and HubrisHobbled Celebrated GoogleIPO,” and its subhead read:“Euphoria Ebbed, TechStocksSagged,TillFirmCutSize; Priced at a Low $85 aShare, Blow to Dutch-AuctionMethod.”

A few days later theWall

Street Journal published acolumnabout theoutlookforIPOs in general. Its headlineread: “Gloomy IPO MarketWonders About Life AfterGoogle’s Entry.” The themeof the article was thedifficulty of selling stockofferings to the public in thecurrent market environment.This was another solid pieceof evidence that no bullishstock market crowd had

formedyet.

The public attitude towardGoogle’s stock was nicelyreflected in a Newsweekcolumn by Allan Sloan thatappeared in the October 11,2004, edition. When Sloanwrote his story, Google wasselling near $130. A weekearlierfiveanalystshadcomeoutwith their initialopinionsof Google’s prospects. Sloanwrote:

Surprise!AllfivegaveGoogle high ratings,even though it was afar more expensivestock than at the IPOjust sixweeks earlier,having risen almost40%. Why investorstook these opinionsseriously is amysterytome.

LaterinthatstorySloansaid:

Atthispoint,Google’sstock is going upbecause it’s going up—not because itsfundamentalsare60%better than when itsolditsinitialofferingin mid-August. ... Atsome point, realitywill seep in ... andinvestors will beginwondering whetherGoogle can earn

enough to justify its$40 billion marketvalue.

ThestoryofGoogle’s IPOin 2004 and of the publicattitudestowarditandtowardthe entire IPO market thenoffersanimportantlessonforthe contrarian trader. InAugust 2004 the marketaverages had not yet enteredzones of potentialovervaluation, according to

my historical tabulations.Therewas no indication of abullishstockmarketcrowdinmy media diary. These twoindications were stronglyreinforced by the publicreactions to the Google IPOand attitudes toward the IPOmarketingeneralatthetime.The conservative contrariantrader would have found iteasy to sit with an above-normal stock market

allocation during this timebecause public attitudestowardthestockmarketwereskeptical if not outrightbearish.Evenbetter,herewasan opportunity to fade abearish crowd focused on asinglecompanyinthecontextof a bull market in theaverages. The aggressivecontrariantraderhastobeonthelookoutforthesekindsofopportunities, because they

willofferchancestoenhancehis performance relative towhat is possible using onlyexchange-traded funds(ETFs), which follow thebroadmarket.

THEHOUSINGBUBBLE

The U.S. stock market

indexes all reached theirbubblehighpointsduringthefirstquarterof2000andthendropped to low points inOctober 2002. Remarkably,the market for owner-occupied housing actuallystrengthenedduringthe2000-2002 bear market and theassociated economicweakness. In fact, housingprices accelerated theirupward trend during that

time. The Case-Shiller indexof U.S. home prices rosenearly90percentbetweenthefirst quarter of 2000 and thesecond quarter of 2006. Thisshould be compared with arise of 30 percent during thesix-yearperiodpriorto2000.The interesting thing aboutthe housing bubble is that itwas widely recognized as abubble by manycommentators at the time it

was inflating, but aswith allbubbles this offered no clueabout how high home priceswould rise and how long thebubblewouldinflate.

This is a lesson forcontrarian traders. Bubblesarealwaysrecognizedassuchbywiseobserversat thetimethebubbleisinflating.Sadly,thisisnohelptotheinvestor;it doesn’t tell you when thebubble is about to pop.

Bubbles as a rule inflate farbeyond any reasonableexpectation. This is why wecall them bubbles. The moststunning example of thisphenomenon in recentmemory was the Japanesestock market and real estatebubbleof1980-1990.

Japan’s Nikkei stockmarketindexhadrisennearly350percentduringthe1970s.As the market rose even

higher during the 1980s onecould read frequentcommentaryonJapan’sstockmarket bubble andpredictions of its imminentdemise. Yes, the bubble didpop in 1990, but not beforethe Nikkei had advancedanother 490 percent duringthe1980s.Thisendeda two-decade bull market, whichhad sent the Nikkei up anastounding 1,850 percent! If

you studied the Japanesemarketinmid-1985whentheNikkei reached the 13,000level,ithavingdoubledintheprevious five years, youwould have been tempted bymarket commentators and bythe historically very highlevel of prices to think thebubblewasabouttopop.Butyou would have had to waitanother five years andwatchthe market advance another

200 percent before youactually heard the poppingsound!

The contrarian traderwouldhavegottensomeearlywarnings that the U.S.housing bubble was in itsterminal phases. The cluescametohimviacoverstoriesin weekly and monthlynewsmagazines.

The first housing market

coverIhaveinmymediafilewas the Fortune magazinecover of its September 20,2004, issue. It shows acartoon of a man sweatingandsaying:“Theysaidpriceswouldgoup forever!! ... andwe believed it!!” The coverheadline asked: “Is theHousingBoomOver?”

This cover expressesskepticism about the housingboom. Sometimes a bearish

cover like this does comeneartheendofabubble.Thisin fact happened in April2000 for the stock marketbubble. As explained inChapter 13, Newsweekpublished a cover story thenasking if the bull market instocks was over! In general,however, a bearish cover inthe midst of a bubble issomething that coveys littleinformation to the contrarian

trader. If anything, it meansthat the bubble is not yetreadytopop.

Thenexttwocoversinmyfiles tell quite a differentstory. The May 30, 2005,issueofFortuneisheadlined:“Real Estate Gold Rush.” Itshows photographs ofindividuals and couples whohaveapparentlymadealotofmoney in the real estatemarket. The subhead reads:

“InsidetheHot-MoneyWorldof Housing Speculators,Condo Flippers, and Get-Rich-Quick Schemers (Is ItToo Late to Get In?).” Twoweeks later, in its June 13issue, Time magazinepublished a cover storyshowing an illustration of aman hugging his home. Theheadline read: “Home $weetHome—Why We’re GoingGagaOverRealEstate.”

At the time these twocovers appeared, in thesecond quarter of 2005, theCase-Shiller housing priceindex stood at 176.70, up 76percent from its level of100.00 in the first quarter of2000. By the second quarterof2006 the indexreached itshigh point at 189.93. Duringthe subsequent two years theindex fell 20 percent to the140level.

While these two coverstories gave fair warning oftheendofthehousingboom,they appeared a full yearbefore the actual peak inhome prices. This is quite acommon phenomenon.Market tops tend to lagbullish magazine covers byanywhere from four to 12months, while market lowstend to lagbearish coversbyonlyamonthorso,ifthat.

Thesecoverstimedthetopof the housing sector of thestock market much moreexactlythantheydidthepriceofhousing.Thehousingstockprice indexes maintained byStandard&Poor’sandbythePhiladelphia Stock Exchangereached their housing bubbletops in July 2005, barely amonth after the magazinecover stories appeared. ByJuly 2008 these indexes had

fallen 85 percent and 70percent respectively fromtheir2005highpoints.

The contrarian tradershould always be on thelookout for media cluesindicatingamaturebullishorbearish crowd. These canarise in unexpected places.Thehousingbubble isacasein point. The year 2005 sawthe debut of two televisionseries devoted to real estate

speculation. “Flip ThatHouse” on the LearningChannel and “Flip ThisHouse” on the Arts &Entertainment network drewgrowing and enthusiasticaudiences. Interestinglyenough, both showscontinued to air through thehousing downturn as theflipperswhose activities theyrecordedbeganlosingmoney.Apparently misery loves

company.

AGGRESSIVECONTRARIAN

TRADINGDURINGTHE2002-2007BULLMARKET

Unlike his conservativecousin, the aggressive

contrarian trader expects tomakeadjustmentstohisstockmarket allocation at least acouple of times each yearduring both bull and bearmarkets.Hisgoalistousehismedia diary and his markettabulations to take advantageof the short-term marketswings that develop withinthe context of any longer-term, multiyear trend. In abull market, for example, a

typical short-term upswingmight carry the averagesupward by 15 to 25 percentand last four to nine monthsor even longer. A typicalshort-term downswing mightlast anywhere from one tothreemonths(andinextremecasesasmuchassixmonths)and carry the averagesdownwardby5to15percent.In a bear market the extentand duration of short-term

upswings issimilar to thatofshort-term downswings in abull market. A similarreversalofparametersappliesto short-term downswings inabearmarket.

Ideally, the aggressivecontrariantraderwillhaveanabove-normal portfolioallocationtothestockmarketnear the low points of short-term downswings and anormal or below-normal

allocationtothestockmarketnear thehighpointsofshort-termupswings.

At this juncture letmesaythat below-normal stockmarket allocations can bedangerous. I don’t think anycontrarian trader should havea below-normal exposure tothestockmarketduringabullmarket. Remember thathaving a below-normal stockmarket allocation during an

extendedupswinginpricesisarecipeforensuringthatyourportfolio’s performance willbeinferiortothatofthebuy-and-holdbenchmarkpolicy.Iurgeallaggressivecontrariantraders to allow their bullmarket stock marketallocations to fluctuatebetween normal and above-normal levels only. Theaggressive contrarian wouldmove to a below-normal

allocation only after he seestheS&Pdrop5percentbelowits 200-day moving average.Abelow-normalstockmarketallocation is justified only ina situation where a stockmarket bubble has likelyformedandisprobablyabouttopop.Inallothersituations,leave below-normal stockmarket allocations to expertcontrariantraders.

Let’s see what tactics an

aggressive contrarian tradermighthaveusedinpursuitofthis objective during the2002-2007 bull market. TheS&P500indexbeganitsbullmarket from a low at 768(intraday) on October 10,2002. The aggressivecontrarian trader would havehadverystrongevidencethatanewbullmarketwas aboutto begin. Certainly mediaevidencethatappearedduring

thesummerof2002revealeda massive, bearishinformationcascade,one thatwas stronger than thoseevident at the March 2001and September 2001 lowpoints. By October 2002 thebear market in the S&P hadlasted 31months and carriedthe average down nearly 50percent,thusmakingitbiggerthan any other bear marketsof the preceding 50 years. I

thinktheconjunctionofthesetwo facts made it reasonablefor the aggressive contrariantrader to act on theassumption that a new bullmarketwasabouttobegin.

The most important thingto remember about the earlystagesofabullmarketisthatthe first short-term swingupward is generally thebiggestoneofthebullmarketinpercentageterms.Itisalso

often the longest in duration.It isdoubly important for theaggressive contrarian tradertomaintainhisabove-averagestock market allocationduring this upswing, becausethis is an opportunity toimprove substantially hisportfolio’s performancerelative to the buy-and-holdstrategy.

How may this importantobjective be achieved? As a

rule you cannot expectmuchhelpfromyourmediadiaryinidentifying the end of thisfirst short-term upswing ofthebullmarket.Even thoughthe bearish stock marketcrowdthatexistedatthestartof the bull market isdisintegrating rapidly, nobullish crowd is likely to beevident yet and no bullishinformation cascade is likelyto be visible in your media

diary.

To solve this problem Isuggested in Chapter 11 arule based on my markettabulations coupled with theuse of the 50-day movingaverage of the S&P 500index.Mymarket tabulationssuggest that one should waitfor the averages to rise atleast 25 percent from theprecedingbearmarketlowinan upswing that lasts at least

six months. Once this hashappened, start watching the50-daymovingaverage.(Thisis just the sum of thepreceding 50 daily closesdivided by 50.) Look for anew bull market high in thismoving average that occursafter the six-month advanceof at least 25 percent. Oncethe moving average turnsdownward by at least 0.5percentofthathigh,youhave

a signal to cut back yourstock market allocation tonormallevels.

I want to emphasize thatthisrule,likeeveryotheroneyou find in this book, is notsome magical formula to beapplied slavishly by everyreader. There is lots of roomfor creative thought—formodifications of the basicidea that these rulesembody.Every trader has skills,

knowledge, and experiencethat are unique. It would besillynot to takeadvantageofyour own knowledge toimproveormodifytherulesIsuggest so that they fitbetterwith your own style andmarketknowledge.

Let’s applymy rule to theinitial upswing of the 2002-2007 bull market. The lowwas at 777 on October 9,2002. The aggressive

contrariantraderwaitsfortheaverage to advance 25percentandforaperiodofsixmonths after this low. Thisrequires an advance to the971 level, which achieves anew high for the upswingafter April 10, 2003. Thesetwo conditions were jointlymet on June 3, 2003, whenthe S&P closed at 972. Thatsame day the 50-daymovingaverage established a new

highforthemoveupfromitsbear market low of 846establishedonApril 4, 2003.The aggressive contrariantrader is nowwatching for adropof0.5percentinthe50-day moving average as asignal to return to a normalallocationtostocks.OnApril28, 2004, with the S&Pclosing at 1,128 this eventoccurred.

Once the aggressive

contrarian trader has reducedhis stockmarket exposure tonormal levelsnear the topofa short-term upswing, hestarts looking to his mediadiary for evidence that ashort-lived bearish crowd isdeveloping near the lowof ashort-term downswing. Hishope is that his media diarywill help him to identify ashort-lived bearishinformation cascade

developingnearthelowpointoftheshort-termdownswing.Forthispurposeheislookingfor page 1 stock marketheadlines in majornewspapers,orseveralpage1stories thatmaynotbemajorheadlines. Even betterwouldbe a magazine cover takingbearishnoteoftheshort-termdownswing in the stockmarket.

He may not get this

opportunity right away andthe averages may continuehigherforawhile.Nomatter.His allocation is normal andhis performance will matchthat of the buy-and-holdinvestorwhile hewaits for ashort-lived bearish crowd todevelop.

InMay2004theonlypage1 story I put into my mediadiary was from the ChicagoTribune’s May 18 edition.

Thestoryappearedabovethefold but was not a headline:“Investors Shaken by WarWoes.” It was accompaniedby a table headed “Dow inDecline.”This table recordedthe extent of the previousthree weekly drops in theDow Jones IndustrialAverage. The preceding day,May 17, the S&P closed at1,084andhaddroppedaslowas 1,079 during that day.

These levels should becompared with those thatended the preceding short-term upswing: an intradayhighof1,163witha closeat1,157 onMarch 5. The dropsubsequenttothathighlastedmore than two months andcarried the average down 7percent by May 17, a short-term downswing well withinnormal expectations within abull market context. At the

May 17 close the S&P 500wasnotquite1percentbelowits 200-day moving averageandwasalsobelowits50-daymoving average. Such acombination in a bullmarketshould alert the aggressivecontrariantradertoapotentialopportunityforincreasinghisstockmarketexposure.AtthetimeIwasverybullish,partlybecause of the Tribune’sstory but mainly because of

generally gloomy,nonheadline commentary inthepress.

Another factor in mybullishness was a dramaticrise in bearish sentiment thatwas apparent in the weeklypoll of individual investorsconducted by the AmericanAssociation of IndividualInvestors.Thiswasconsistentwith a rise in put optionbuying (by investors betting

onfurthermarketdeclines)inthe options markets, whichalso became evident at thetime.

But let’s suppose youdidn’tactonthisinformationbecauseyouwerelookingforstockmarketheadlines in theNew York Times. Noneappeared, so you maintainedyour normal allocation tostocks.Youwould stickwiththis allocation until a short-

term drop in the S&P wasaccompanied by a bearishinformation cascade. As ithappened, this opportunitywould take almost anotheryear to develop. But this isnot a bad thing since duringthis waiting period theaggressive contrarian traderwould have matched theperformance of the buy-and-holdpolicy.

Tomakesurewecoverall

the bases, let’s consider howan aggressive contrariantrader who did increase hisstock market allocation toabove normal in May wouldhave acted during the nextupswing. The short-termdownswingendedintheS&Pat the 1,063 level onAugust12.Atwhat point during thesubsequent short-termupswing should he move hisstock market allocation back

downtonormallevels?

Here is the way I answerthis question. Before Iconsider moving my stockmarket allocation back tonormal levels, I want to seethe S&P advance 15 percentfrom its short-term low andmakeanewhighfor thebullmarket. The 15 percentnumber isnotamagicone. Igenerallyadjust it as thebullmarket ages, generally in a

downward direction. Youmay want to modify thispolicy by incorporating othercontrarian information ortechnical indicators you areskilledinusing.

The aggressive contrarianwho is following thestrategyoutlined inChapter 11mighttime his reduction of stockmarket exposure to normallevels in a different way byusing the 50-day moving

averageoftheS&P.

Fortheshort-termupswingthat developed from theAugust 2004 low at 1,063, a15 percent advance wouldtaketheS&Pto1,222,whichwas also a new high for thebull market. On March 4,2005, the S&P closed at1,222 and the aggressivecontrariantraderwouldrevertbacktoanormalstockmarketallocation if he had been so

fortunate as to maintain anabove-normal allocationduringtheupswing.

APRIL2005—ABUYING

OPPORTUNITY

At this juncture theaggressive contrarian trader

mayhavebeen sittingwith anormal stock marketallocation since April 28,2004,whentheS&Pclosedat1,128. If hewas very skilledhemayhavegonebacktoanabove-normal allocation onMay 18 at the S&P 1,084level and then reverted to anormal allocation on March4, 2005, with the S&P at1,222.

Traders would now be

looking for a short-runbearish information cascadeto indicate the presence of abearish crowd near the lowsof a normal short-termdownswing within theongoing bull market. Thisgenerally requires one ormore page 1 stock marketstoriesrecountingthedropinthe averages or at least onenewspaperheadlinedoingso.Even better would be one or

more magazine coversexpressing bearish attitudesaboutthestockmarket.

On April 16, 2005, thefront page of the New YorkTimesfeaturedastockmarketstory that wasn’t a headlinestorybutdidappearabovethefold at the top leftaccompaniedbyachartofthefalling Dow Industrials. Thestory’sheadlineread:“StocksPlungetoLowestPointSince

Election.”The positioning ofthis story and the headline’suse of the word plunge andthe phrase lowest point alladded significance andweight as indicators of abearish information cascade.On April 18 the New YorkTimes page 1 headline read:“As Stocks Slide InvestorsFocus on Earnings Data.”And then in the April 21edition of the New York

Times we find an above-the-fold story headlined:“Inflation Fears PummelStocks; New Lows for ’05.”Any of these three storieswouldhave sufficed tomovethe aggressive contrariantrader to an above-normalstock market allocation. OnApril 15 (a Friday) the S&Pclosed at 1,143 and onApril20 it closed at 1,138. Thedrop from theMarch high at

1,225had lastedmore thanamonth and carried theaverage down more than 6percent, well within normalparameters for short-termdrops in a bull market.Moreover, on April 15 andfor a few days afterward theS&Pwas trading not quite 1percent below its 200-daymoving average and alsobelow its 50-day movingaverage.

Having established anabove-normal stock marketallocation, the aggressivecontrarian trader would waitfor an advance carrying themarketup15percentfromits1,138 low established onApril 20, 2005. Thishappened on April 6, 2006,with the S&P closing at1,311. At that time theaggressive contrarian traderwouldmovebacktoanormal

stock market allocation. Hethen would await evidencefrom his media diary thatanother short-run bearishinformation cascade wasunderway.

JUNE2006—ANOTHERBUYINGOPPORTUNITY

TheS&Pestablishedashort-term swing high on May 8,2006, at the 1,327 level.Thesubsequent short-term dropended at an intraday low of1,219onJune14.Thiswasadroplastingalittlemorethana month and carrying theS&Pdownabout8percent,aperfectly normal short-termdownswing in a bull market.The evidence for a short-runbearish information cascade

during this short-termdownswingwasnotasneatasduring theMarch-April 2005downswing,butitwasclearlytheretosee.

Thesinglemostsignificantpiece of evidence was amagazine cover story. TheMay 27 issue of theEconomist had a covershowing a photograph of abrown bear standing on itshind legs and peering out

frombehindatree.Thecovercaptionread:“WhichWayIsWallStreet?”BythetimethisissueappearedonMay26theS&P had already dropped aslowas1,245onMay24.Thiswasa6percentdropfromitsMay8highovera two-weekperiod—all in all a bit brieffor a normal short-termdownswing. Even so, theS&P500wasagaintradingalittle below its 200-day

movingaverageandbelowits50-day moving average. Theaggressive contrarian tradercould have justifiedincreasinghisstockallocationto above normal as soon asthe S&P returned to or fellbelow its May 24 low. ThishappenedonJune8whentheaverage dropped as low as1,235 intraday and closed at1,258.

Moreevidenceforashort-

run bearish stock marketcrowd was to follow. TheJune11SundayeditionoftheNew York Times Magazinehadonitscoveracartoonofahairy, red bogeyman labeled“debt” and crowds of peoplerunning from him in terror.Thecaptionread:“America’sScariestAddiction IsGettingEven Scarier.” While thiscover didn’t deal with thestockmarketdirectly,Ifeltat

thetimethatitreflectedfairlythe tenor of public attitudestoward the stock market andthe economy and sointerpreted it as part of ashort-run bearish informationcascade.

Thefinalpieceofevidencewas also delivered by theNew York Times. In its June16 edition there appeared onpage 1, below the fold, agraph of the Dow Jones

Industrial Average thatemphasized the big declinefrom its May 10 high. Itscaptionread:“Relief,atLeastfor Now.” The explanationbelowthecaptionendedwiththe sentence: “But theincreased volatility in themarkets suggested that theirtroubles may not be over”(my emphasis). The low forthis short-termdownswing inthe S&P had occurred two

daysearlier.

We see then that anaggressive contrarian traderwould have had good reasonto move his stock marketallocationuptoabovenormalsomewhere below the 1,260level in the S&P. The lowclose was 1,224 on June 13.Adding 15 percent to thisyields 1,408. The S&Preached this level onDecember 4, 2006. At that

timetheaggressivecontrariantrader would have cut backhisstockmarketallocationtonormallevels.

AGGRESSIVECONTRARIANTRADINGINEARLY2007

The next opportunity for theaggressive contrarianoccurred during February-March 2007. The February28, 2007, edition of theChicago Tribune washeadlined: “China MarketPlunges, Dow Follows. NowWhat?” The headline wasspread across the entire frontpage of the paper in boldlettering and wasaccompanied by a line chart

that recorded the progress ofthe steep, 416-point drop inthe Dow Industrials theprevious day. It wassubheadlinedastheworstdaysince 9/11 (the date of the2001 attack on New York’sWorld Trade Center). Thestock market drop was alsoheadlinedthatdaybytheNewYork Times: “Slide on WallSt. Adds to Worries AboutEconomy ... Fears of

Recession Grow.” Thisheadline was not nearly sodramatic as the Tribune’s; itappeared only over the firstcolumn in normal headlinetype. It was, however,accompanied by a chartdepictingdropsintheworld’sstock markets that spreadacrossmostofthetoppartofthefrontpage.

Media interest in the stockmarket break fell off after

February 27, but did notdisappearentirely.TheMarch11 edition of the New YorkTimes printed a “NewsAnalysis” by GretchenMorgensononpage1, abovethefoldandrightnexttothatday’s headline story. Theanalysis was headlined:“CrisisLoomsinMortgages.”It detailed the financialtribulations of mortgagelenders, in this case New

CenturyFinancial,whichhadspecialized in the subprimesegment of the mortgagemarket.OnMarch14,thedayof the market low, theWallStreet Journal headlined:“Subprime Fears Spread,SendingDowDown1.97%.”These two stories are amongseveral in my diaryassociating the February-March stock market dropwith a subprime mortgage

crisis.They illustrate the factthat there is a cascadelikeaspect to even very briefbearish stock marketepisodes. One news storyfeed inspires the next asjournalists race to commentand explain the latestdevelopments.

Sometimes importantcontrarian clues are moreephemeral than the ones Ihave just mentioned. On

February 27 and again onMarch2InotedinmymediadiarythatJayLenohadmadethestockmarketdroppartofhis opening monologue onthe Tonight Show. OnFebruary 27 he opened byobserving that people didn’thave any money anymorebecausethestockmarketjustdropped 500 points (hisemphasis). Even acomedian’sjokescantellyou

something about the temperofthecrowd!

The 7 percent drop in thestock market averages thatended at the March 14 lowlasted barely three weeks. Itwas mild and brief in anyhistorical context. But muchto my surprise at the timethere were three weeklynewsmagazine covers thateither mentioned or focusedonthisstockmarketdrop.

The firstwas theMarch3,2007,issueoftheEconomist.Its cover was headlined “AWalk Down Wall Street.”Thesemioticinterpretationofthis cover was easy. First, itwas in black and white, adepressing combination forany cover story. Second, itdepicted the feet of a personwalking a tightrope, a verydangerous, potentially deadlyactivity. Finally, the headline

itselfusedtheworddown.Allinall,thiswasacoverwithaclearbearishbias.However,Ithink that among all bearishcover stories Ihaveseen thisonewasonlymildlyso.

The second covermentioning the stock marketwas that of the March 12issue ofTimemagazine. Thecover itself was devoted tofood, but in smaller greenprint against a white

background at the top of thecoverwasthequestion“IstheStock Market Getting TooRisky?” Here I note the useof the negative word risky.This was evidence ofsomething we already knewfrom newspaper headlinesand from the Economist’scover a week earlier—thestock market drop hadinvestors worried. Even so,the fact that Time magazine

noted the drop on its coverwasamodestbullishclueforthe aggressive contrariantrader.

The March 12 issue ofBusinessWeek also had astock market cover. But thecover had little emotionalcontent, and it is theemotional content of amagazine cover that revealsinformation about andconveys information to

investment crowds. Thiscover was headed “What theMarket Is Telling Us.” Butyouhadtoopenthemagazineto find the answer, makingthis particular coverinsignificant from acontrarian trader’sperspective.

An aggressive contrariantrader would have found atrading opportunity in theseheadlines and cover stories.

The S&P had established anewhigh for the bullmarketatthe1,460levelonFebruary20. It is certainly true that aweek is never enough timefor an honest bearish crowdtodevelopviaaninformationcascade, even amidst anongoing bull market. But bymid-March, after a three-week, 7 percent decline, thesituation had changed. Abearish information cascade

was under way, although itwas a relatively mild one.And the S&P had droppedenough to pique my interestinincreasingmystockmarketallocation.

I noticed in my tabulationof reactionswithin the 2002-2007 bull market that themedian drop during the bullmarket thus far had beenabout 100 S&P points andthattheminimumdurationof

such drops was about threeweeks. (Note that thesenumbers are specific to the2002-2007 bull market andwill be different in othercontexts.) The S&P 500 hadreached the 1,462 levelintraday on February 22 anddroppedto1,389onFebruary27.Thiswas a73-pointdropinonlyfivedays.AtthetimeI believed that while it waslikelythemarketwascloseto

its low, there was probablymore to come on thedownside. Indeed, the actualintraday low occurred onMarch 14 at 1,364, 18 daysafterand98pointsbelowtheFebruary 22 top. From themoving average perspective,theclosest theS&Pgot to its200-daymovingaveragewasat theMarch13 lowcloseof1,378, where it was 2.16percent above the moving

average. At the same time itwasbelowits50-daymovingaverage. I believed then thatthis combination ofcircumstances justified goingto an above-average stockmarketallocation.

The aggressive contrarianwho assumed an above-average stock marketallocation in March 2007would expect to reduce thisallocation to normal levels

after a 15 percent advancefrom the closing low of thereaction. In this case thatlevel was 1,584 and wasnever reached before a newbear market began. Had theaggressive contrarian chosento adopt the 1,364 intradaylow as the starting point forhis measurement, he wouldhave reverted to a normalstock market allocation onOctober 11 when the S&P

reached an intraday high of1,576. But let’s suppose hedecidedtoactonlyonclosingprices instead. What mightthe aggressive contrarianhavedonethen?

Of course the simplestthing to do would be tofollow the strategy describedin Chapter 11 exactly. Thusthe aggressive contrarianwouldresolvetocuthisstockmarket allocation to normal

aftera15percentadvanceonthe low reaction close or tobelow normal if the S&Pshould drop 5 percent belowits 200-day moving average.In theevent, itwas the lattercondition that first obtained,and the aggressive contrarianwouldhavereducedhisstockmarket exposure to below-normal levels on November26, 2007, when the S&Pclosed at 1,407,more than 5

percent below its 200-daymovingaverage.

A more sophisticatedapproach to this kind ofsituation would rely on bullmarket tabulations. In thiscase, by mid-2007 the bullmarkethad lastednearly fiveyears and had not seen anyreaction of as much as 10percent. This was anextraordinary run of positivereturns,onethatwasunlikely

tolastmuchlonger.Ithinkinviewofthesecircumstancesitwould have been perfectlylogical for the aggressivecontrarian to adopt a moreconservative profit-takingtactic and to reduce stockmarket exposure to normallevels as soon as the S&Prallied only 10 percent or so(instead of waiting for a full15percent)toanewhighforthe 2002-2007 bull market.

This event occurred on May15, 2007, with the S&P at1,514.

Before leaving the eventsof February-March 2007 Iwant to mention anotheraspect of this bearishinformation cascade thatimpressedme.Iwassurprisedto find three stock marketcovers generated by arelatively modest drop instock prices. Normally one

needs a much more long-lasting and extensive declinebeforenewsweekliesputitontheircovers.Iinterpretedthisas furtherevidence that therewas no significant bullishstock market crowd inexistence at the time. Notonly was there no bullishtheme evident, but therewasa decided media tendency toprint bearish stories at thedrop of a hat. People were

willing to express pessimismandnegativeemotionsontheslightestmarket pretext. Thisreaffirmed my view at thetimethattherewasnobullishstock market informationcascadeinoperation.

JULY-OCTOBER2007

On July 17, 2007, the S&Pclosed at 1,553. Itwas aboutto drop some 10 percentduringthesubsequentmonth,a bigger short-termdownswing than any duringtheprecedingfouryears.Thisdecline presented theaggressive contrarian traderwith another opportunitysimilar to the one heexploitedinMarch.

The progression of page 1

stories during this July-August decline is instructive.TheNew York Times printedstock market stories on page1at the top left onboth July27 and July 28. Both notedthe stockmarketdrop,whichby then had lasted for about10 days and dropped theaverages about 4.5 percent,not enough to attract theinterest of an aggressivecontrarian. The drop was

explainedbythereemergenceofcreditmarketfears.

The first headline storyappeared in the August 4edition of the New YorkTimes. The headline read:“Markets Tumble As LenderWoes Keep Mounting.” Asheadlinestoriesgothiswasamild one. The language usedwas conservative—themarkets “tumbled”; theydidn’t “plunge” or “crash.”

The print size was normal,and the headline appearedoveronlyasinglecolumn.

The previous day (Friday)the S&P closed at 1,433,about8percentbelowitshighclose. The decline had lasted16days,stillshyofthethree-week tabulation standard andeven shy of the duration ofthe February- March 2007break. Still, the S&P wastradingabout1percentbelow

its 200-day moving averageandbelowits50-daymovingaverageatthetime.Ithinkanaggressive contrarian traderwould be justified inincreasing his stock marketallocationatthisjuncture,andthis could have been doneearly Monday morning at alevelclosetoFriday’sclose.

The drop in stock pricesfrom the July top ended onAugust16attheS&P’s1,371

level. There was one moreheadlinestorybeforethelow,this one in the August 10issueoftheNewYorkTimes.Theheadlineread:“MortgageLosses Echo in Europe andon Wall St.” The previousday theS&Pclosedat1,453,a level above that whichpreceded the August 4headline. So the aggressivecontrarian trader would havegained nothing by waiting

pastAugust6 to increasehisstockmarketallocation.

The end of this drop instockpricesonAugust16canclearly be associated with acrystallizing event that hadoccurred a few days earlier.This was a massive creditmarket intervention by theFederal Reserve and othercentral banks that took placeon August 10 and wasrecorded in newspaper

headlines on Saturday,August11.ThatdaytheNewYork Times headlined:“Central Banks Intervene toCalmVolatileMarkets.”Thisheadlinewasspreadovertwocolumns, as opposed to thesingle column occupied bythe August 4 and August 10headlines,thusshowingmoreemotional intensity. Thisevent was also headlined bytheChicagoTribune thatday

with“JitteryMarketsLooktothe Fed” in bold letters,spreadacross the topofpage1 and accompanied by aphotograph of a worriedtraderattheNewYorkStockExchange.

The July-August stockmarket drop also promptedsomemagazinecoverstories,but,likethoseassociatedwiththe February-March decline,these appeared only in

business-focused magazines,not those of general interestlike Time orNewsweek. TheAugust 13 issue of Barron’shad a cover announcing“MarketTurmoil”inboldredletters against a blackbackground.Froma semioticpoint of view I note that redand black are colorsassociated with fear anddanger. The August 18 issueof the Economist showed a

cartoonofaninvestorsurfingshark-infested waters andabout to suffer a surfer’swipeout (note the doublemeaning). The headline read“Surviving the Markets.”Finally,theSeptember3issueof Fortune (which wouldhave been in subscribers’hands around August 24)sported a black cover thatshouted “Market Shock2007” in bold red and white

lettering. Compared to theMarch2007magazinecoversI discussed earlier, thesecovers conveyed somewhatstronger bearish sentiment.This would have furtherreinforced the aggressivecontrarian trader’s choice toincrease his stock marketexposureearlierinAugust.

After assuming an above-normalallocationtothestockmarket in August, the

aggressive contrarian wouldprobably have reduced hisexposure to normal levels ona10percentadvancefromtheclosing low at 1,406 onAugust 15. This occurred onOctober 1 when the S&Pclosed at 1,547. The S&Preached itshighclose for the2002-2007 bull market onOctober 9 at the 1,565 level.Thecurtainwasabout to riseonthepanicof2008.

CHAPTER15

ThePanicof2008

Theremarkable2002-2007bullmarket •nobullish crowd evidentatthetop•thebullishcrowd in the housing

market • bear marketsignal •whenwill theconservativecontrarian increasehis stock marketexposure? • themortgage mess • adebt-deflation spiral •the government stepsin • credit crisis andthe aggressivecontrarian trader •breaking below the

moving average •failure of BearStearns in March2008 • Fannie andFreddieinJuly2008•the crash • worldpanicinOctober2008• an amazingsequence ofmagazinecovers • theaggressive contrariancontemplates a newbullmarket

THECONSERVATIVECONTRARIANDURINGTHE

PANIC

From its low at 777 inOctober 2002 to its high at1,565 in October 2007, theS&P 500 index more thandoubled. This was an

unusually long bull market,exactly fiveyears induration—longerthanthetypicalbullmarket, which lasts two orthree years. The 100 percentgain in the averages was notas unusual, although a 65percentgainwouldhavebeenclosertotheaverage.

To me as a contrariantrader the remarkable thingabout the 2002-2007 bullmarket was the persistent

pessimism expressed in themedia about the U.S.economy and the stockmarket during those fiveyears. There was never anyindication inmymedia diarythat a bullish stock marketcrowdhadformed.

However, as I pointed outin the previous chapter, avery big, bullish investmentcrowd had formed in theresidential housing market,

not just in the United Statesbut around the world. InOctober 2007 it was hard toimagine that the collapse ofthis housing bubble wouldhave the devastatingconsequences for theworld’seconomy, financial markets,and banking system thatdeveloped during thesubsequent12months.

From its closing high of1,565onOctober9,2007,the

S&Pdroppedtoaclosinglowof 752 on November 20,2008,adeclineof52percentinbarelymorethanayear.Aconservativecontrariantraderwho followed the ContrarianRebalancing strategy wouldhave reduced his stockmarket allocation to normallevels on January 6, 2006,with the S&P at the 1,285level. The 200-day movingaverage of the S&P turned

downward from its bullmarket high by 1 percent onFebruary 20, 2008,when theS&Pclosedat1,360.Butthisevent would cause a furtherreduction in stock marketexposure only if theconservative contrarianbelieved that a bullish stockmarketcrowdhad formedby2007. I for onedidnot thinkso,butIknowotherinvestorswho did. Consequently I did

not interpret the 1 percentturndown in the 200-daymoving average as a signalfor the conservativecontrarian to move to abelow-normal stock marketallocation.

In either case, it isimportant to remember thatthe panic of 2008, asterrifying as it was, did nothurt the conservativecontrarian’s portfolio

performance relative to thebuy-and-hold benchmark.And it is only hisperformance relative to thisbenchmark that matters. Thename of the game everycontrarian trader plays isbeating the benchmark, notbeing right about the stockmarket’sdirection.

Asthis isbeingwritten(inlate November 2008), theconservative contrarian is

awaitingaturnupwardinthe200-day moving average inthe S&P 500 by 1 percent.Thiswill be a signal that thepanic of 2008 is history andthat a new bull market hasbegun. An enormous bearishstock market crowd hasformed in the stock market,not just in the United Statesbut around the world. Sowhen the moving averageturns up by 1 percent, the

conservative contrarianshould plan to increase hisstock market exposure toabove-normallevels.

There is noway topredictwhenandatwhatprice levelthis moving average upturnmight develop. At themoment the 200-daymovingaverageof theS&Pstandsat1,244 and is dropping at therate of about 50 points permonth.Noturnupwardinthe

movingaverageislikelyuntilthe S&P rises above it.Currently the S&P stands at800. From this data it isreasonable to conclude thatthe moving average upturnlies several months in thefuture.

Intherestof thischapterIfollowthedevelopmentofthepanic of 2008 through theeyes of the aggressivecontrarian trader. First,

though,Iwanttoexplainjusthowandwhythepanicarosefrom the collapse of thehousingbubble.

THEMORTGAGEMESS

What caused the panic of2008? In a word, mortgages.When the housing bubble

burst, the resultingunexpecteddropinresidentialhome values led manyborrowers to default on theirmortgages. But thesemortgageshadbeenpackagedinto bonds called mortgage-backed securities. Worse,even more complicatedsecurities calledcollateralized debtobligations weremanufacturedfrommortgage-

backed securities by WallStreet banks in order tosatisfy the demand byinvestors for higher yields ina low-yield bond market.Mortgage defaults arisingfrom falling home pricesmade it very difficult todetermine the value of thesecomplex securities. Theresimply was no historicalprecedent for what washappening. Residential home

prices had not declinednationally in real terms sincethe 1930s and even thatdecline was smaller that theone experienced in the U.S.between 2006 and 2008.Because these complexsecurities were so hard tovalue objectively the bondmarket assumed the worseandconsequentlytradedthematverylowprices.Thisraisedthe specter of mass

insolvency for banks andother financial institutionsthatownedthem.

Whatisamortgage-backedsecurity? It is a long-termbond created when aninvestment bank buysportfoliosofhomemortgagesfrom themortgage originator(usually a commercial bankor mortgage loan company)and bundles them into asingle portfolio. It does this

by transferring ownership ofthese mortgages to a specialpurpose entity (sometimescalled a SpecializedInvestmentVehicleorSIV—this is usually a trust ornonprofit corporation). Thisspecial purpose entity thenissues bonds (mortgage-backedsecurities)whosesalefinances the investmentbank’s original purchase ofthese home mortgages.

Mortgage-backed securitiespromise theirownersaseriesofpaymentsfromthepoolofmonthlyinterestandprincipalpayments made by themortgage borrowers,homeownerslikeyouandme.

So far this seems astraightforward process offinancial intermediation.Securitizationofportfoliosofilliquid home mortgagesconverts them into a more

liquid asset and at the sametime reduces the risk tomortgage lenders that canarise from, say, economicdifficultiesspecifictoasinglegeographic housing market.In this way mortgagesecurities make homefinancing cheaper and easierfortheaveragehomebuyer.

The value of a mortgage-backed bond depends on theinterest and principal

payments homeowners areexpected to make on themortgages that make up theportfoliobackingthebond.Itwas from the process ofevaluating these expectedpayments that trouble arose.The trouble was greatlyamplified by the fact thatmortgage-backed securitieswere often repackaged intoeven more complexsecurities, collateralized debt

obligations, in a processcalledstructuredfinance.

The dramatic increase inU.S. home prices during the1996-2006 period movedthem to levels at least 30percent above constructioncosts,adivergencethatinthelong run was unsustainable.Even so, people began tobelieve that the price ofowner-occupied housingcould only go up.Thismade

the prospective mortgageborrower see a homepurchase as an essentiallyriskless investment. Worse,mortgage lenders viewedmortgage loans in essentiallythe same way, as risklessassetswhose valuewould beprotected by ever-rising realestateprices.Theconvictionsofbothborrowersandlendersthat the price of owner-occupied real estate would

only go up reinforced eachother. Not only did thedemand and the supply ofmortgage loans go up, butthis increase in mortgagecredit further fueled theadvance in home prices. Areal estate bubble was theresult.

As in any credit bubble,lenders gradually loweredtheir lending standards incompetitiontooriginatemore

andmoremortgageloansandearntheresultingfees.Itwashere that the financialtechnology of the mortgage-backed security short-circuited prudent mortgagelending standards. No longerdid loan originators—banksand home-loan institutions—have to keep mortgages ontheir books. Instead theybundled thesemortgages andsold them to investment

banks. Since they did notretain the mortgage loansthey originated in their owninvestment portfolios, theyhad little incentive to makesure such loans could beserviced and repaid by theborrowers.

As long as home priceswent up, these lax lendingstandards caused noproblems. In fact, thehistorical data used to

estimate the chances of themortgage loans being repaidshowed thateven low-qualityborrowers, the so-calledsubprime borrowers, hadgood repayment records.After all, home prices onlywent up, didn’t they? Thisdata was used by ratingscompanies like Standard &Poor’s (S&P) and Moody’sInvestors Service to justifyrating even those securities

backed by subprimemortgages as AAA quality,especiallyaftertheyhadbeenrepackagedintocollateralizeddebtobligations.

Fewpeople thought to askwhat would happen if homeprices stopped going up and,worse, started to fall. Eventhose who did ask thisquestion and knew thatproblemswouldarisedidnothave any idea of just how

destructive to balance sheetsthe drop in the value ofmortgage-backed bondswouldbe,andofthecomplexsecurities that structuredfinance would produce fromthem.

According to theS&P/Case-Schiller index ofU.S. home prices, the valueof owner-occupied housingpeaked in mid-2006. Duringthe subsequent two years

home prices dropped morethan 20 percent nationally.People who had purchasedhomes at the height of theboomduring2003-2006withsmalldownpaymentswereinfinancial trouble. In manycasesthedropinhomepricesmade their mortgage debtexceed the value of theirhomes. This led to anincreaseinmortgagedefaults,especially among subprime

borrowers. Suddenly therepayment expectations thatsupported the beliefs aboutthevalueofmortgage-backedbondswereprovenwrongbyevents.

Butthesituationwasmuchworse than that. The realestate market had enteredtruly uncharted territory.Therewasnohistoricalbasisfor estimating the rate atwhich subprime borrowers

would default as housingprices fell and put them innegative equity situations.The same was true for othermortgage borrowers as well,for the United States hadnever experienced anextendedperiodoftimewhenthe real price (i.e., theinflation-adjusted price) ofowner-occupied housing hadfallensubstantially.Whenthefair value of any security

cannot be compared to anyhistorical norm at all, thesecurity isprone tobepricedon the basis of fear. This iswhat happened during 2008in the market for mortgage-backed securities andcollateralized debtobligations. The values ofmanyofthesesecuritieswereset at levels often 70-90percent below their purchaseprices of only a year or two

earlier.

THEDEBT-DEFLATION

SPIRALTAKESHOLD

Once the value ofmortgage-backed bonds began to fall,fear cascaded through the

world’s financial markets.Any bank, insurancecompany, hedge fund, orother financial institutionwithasubstantialportfolioofmortgage-backed bonds sawthe equity of its shareholdersplummet as these securitiesweremarked down to valuesthat were much lower thantheirpurchaseprices.Inmanycasestherewasnomarketforsuch securities at all.

Consequently,othersecuritiesthat had viablemarketsweresold in order to financeholdings of the mortgage-backed securities that had nomarket.

As the net worth ofinstitutions with substantialholdings of mortgagesecurities dropped, the valueof their bond and short-termloan liabilities naturally wascalledintoquestion.Thiswas

an especially dangerous turnof events because no oneseemed to know whichfinancial institutions wereabout to take substantiallosses on these mortgagesecurities.

Safetyatanypricebecamethe byword. Deleveragingbecametheoperationalpolicyof financial institutions.Banks refused to lend to oneanother or to their business

customers. Corporationscould not borrow in thecommercial paper market.The normal business offinancial intermediationground to a halt as thedemand for immediate loanrepayment spiraled upward.Thiswasthestartofaclassicdebt-deflation spiral, sofeared by economists whostudy the business cycle.Suchspiralsbeginwhenthere

isasuddenrushtosellassetstorepayloans.Thisdrivestheprice of assets downward,makingitevenmoredifficultto repay loans, thus spurringfurtherassetsales.Theentireprocess, if left alone, willdrive the economy into adepressionfromwhichitwillbe very difficult to recover.The Great Depression of the1930s is the classic exampleofadebt-deflationspiral.

LENDERSOFLASTRESORT

Asthepanicof2008begantoaffect markets worldwide,centralbanksandgovernmentfinancial regulators steppedin. During the July-October2008periodlargenumbersofgovernment-financed lendingprograms were announcedand implemented. If banks

and other financialinstitutionswouldnotlendtoone another, then perhapstheywouldbewillingtolendto or borrow from thegovernment or from thecentral bank. In this waycentral banks and nationaltreasuries around the worldassumed the role of financialintermediation that had beentemporarilyabandonedbytheprivate sector. They had

become the true lenders oflast resort in the worldeconomy.

Has government actionhalted the debt-deflationspiral in time to prevent aworldwide depression? As Iwrite this in November of2008 my view is that it has,butonlytimewilltell.Inthisregard it is important tocompare the events of 2008with the events that

accompanied theonsetof theGreatDepressionin1929.

Then as now there was afinancial bubble whoseunwinding caused bankfailures and mortgagedefaults. The big differencecan be found in thegovernmental response tothese developments.Government spendingnow isa much bigger part of theworldeconomythat itwasin

the 1930s, and this makesfiscalpolicynowmuchmorepotent and able to cushioneconomicdownturns.Ofevenmore importance is thewidely held belief thatintervention to control thebusiness cycle is appropriate,especially in downturns. Inthe 1930s few policymakersheld this view, especiallybecause they believed thatadherence to the gold

standard was essential tolong-runprosperity.

Finally, central banks,especially the U.S. FederalReserve,arenowtakingveryseriouslytheirresponsibilitiesas lenders of last resort, ofacting as financialintermediaries in times ofcrisis.This, after all,was thereason that most centralbanks were created.Moreover, the current Fed

chairman, Ben Bernanke, isan expert on the policyfailuresthatcreatedtheGreatDepressionandisdeterminedtoavoidthem.Ifonlyforthisreason,Ithinkthatthingswillturn out differently this timeandthattheUnitedStatesandthe world economy willrecover relatively quicklyfromthisfinancialfiasco.

THECREDITCRISISANDTHECONTRARIAN

TRADER

It is unusual for anyeconomiccrisistolastaslongasthepanicof2008hasdone.It has been a financial crisisin several acts. The curtainfirstroseinJuly-August2007

with thefailureof twohedgefunds sponsored by theinvestmentbankBearStearnsthat invested in mortgage-backed securities. Eachsubsequent act of thisterrifying play had its ownbearish information cascade,which focused on a new setoffinancialfearsanddangers.Each ended with acrystallizing event in whichwhathadbeenfearedbecame

a fact. After a briefintermissionofinvestorreliefandmarketrallies,thecurtainwouldgouponthenext,evenmore fearful act. As this isbeing written, in lateNovember 2008 shortly aftertheelectionofBarackObamato the presidency of theUnited States, no one can besure whether the curtain willrise yet again to reveal yetanother unanticipated

financialdisaster.

I have never witnessed somany intense, bearishinformationcascadesduringa12-month period during my40 years of involvement inthe financial markets. As weshallsee,thesecascadeswerecreated and accompanied bymany dramatic newspaperheadlines and by anunprecedented torrent ofbearishmagazinecovers.

As I pointed out earlier inthis chapter, the conservativecontrarian trader has onlymatched the performance ofthe buy-and-hold strategyduring 2007 and 2008. Asthis is written, theconservative contrarian isawaitinga1percentupturninthe 200-day moving averageof the S&P 500. When thisoccurs he will move from anormal to an above-normal

stockmarketallocation.

In contrast to hisconservative cousin, theaggressive contrarian hasbeen far more activethroughout the crisis. In therestofthischapterwefollowhim as he reacts to theinformation cascadesoccurring during late 2007and the first 11 months of2008.

BULLMARKETTOPANDTHE

FIRSTSTEPDOWN

The S&P 500 started its2007-2008 bear market froma closing high of 1,565,reachedonOctober9,2007.

The first subsequentindication that a bearishinformation cascade had

begun was the headline forthe November 8, 2007,edition of the New YorkTimes. It read: “Markets andDollar Sink As U.S.Slowdown Grows.” I notethat on the semiotic scale ofbearishness this was a verymild headline.Why? First, itdoes not mention the stockmarket explicitly—note theuse of the plural formmarkets. There was a first

column subheadingmentioningtheDow,butthatsame subheading alsomentioned the prices of oiland natural gas. There wasalsoasubheadingmentioningthathomeownerswerefeelingthe pinch of reduced equity.The words pinch and sinkconvey only mild bearishemotions.OverallIwouldsaythat this was not a headlinethat indicatedanything likea

mature bearish stock marketcrowd in existence. It onlyshows that a bearishinformation cascade wasunderway.

About three weeks later,the aggressive contrarianadoptedabearmarket stancewhentheS&Pclosedat1,407onNovember26, 2007.Thatwas the first time in nearlyfiveyearsthattheS&Pclosedat least 5 percent below its

200-day moving average. Atthis juncture the aggressivecontrarian would assume abelow-normal stock marketallocation.

Seven more weeks passedbeforeasecondbearishstockmarket headline appeared inthe New York Times. In theJanuary 17, 2008, edition,over two columns, theheadline read: “Fed Chief’sReassurance Fails to Halt

StockPlunge.”Theuseofthewordplunge and the explicitmention of the stock marketmake this a more decisivelybearishheadline than theonethatappearedonNovember8.The only semioticconsideration diminishing itsbearish message is that thestockmarket is the object ofthesentence,notitssubject.

AftertheJanuary17close,the aggressive contrarian

wouldnote that theS&P500was trading more than 10percent below its 200-daymovingaverage.Ifheweretojudge that the bearish stockmarket crowd had grown bigenough, this would justifyincreasing his stock marketexposure to above-normallevels on the S&P close at1,333thatday.

There was only one thingthat might have caused the

aggressive contrarian traderto delay increasing his stockmarket commitment at thatjuncture. He believed that abearmarketwas in progress.There was as yet only thissingle headline suggestingthat a bearish stock marketcrowd had formed, and therewasasyetnomagazinecovercommentingonthedrop.Thislack of evidence, despite asubstantial drop in the

averagesduringtheprecedingthree months, would havemade some aggressivecontrariansdeferaction.

Only a few days later, onJanuary 22, the situation hadchanged. The U.S. marketshad been closed the previousday,MartinLutherKingDay.But overseas markets wereopen. The headline of theNewYorkTimesread:“WorldMarkets Plunge on Fears of

U.S. Slowdown.” Thisheadline was very dramatic,spread across four columnsand accompanied by severalcolorphotographs.Onewasachart showing the previousday’s minute-by-minute dropintheNikkei225indexoftheTokyo Stock Exchange. Theother showed a worriedcrowd of investors in Indiaand turmoil on the floor of aBrazilianstockexchange.

Asemioticinterpretationofthis headline reveals its verybearish quality. First, “worldmarkets”is thesubjectof thesentence,whichalsouses thewords plunge and fears todescribe the situation. Theheadline appears across fourcolumns and with colorphotographs. One photoshows a chart of the drop ofthe Tokyo stock exchangeindex. The others show

worriedandfrantic investors.Overall, I take this headlineas very convincing evidencethat a bearish stock marketcrowd had formed. This wasgood reason for theaggressive contrarian traderto increase his stock marketexposure,somethinghecouldhavedoneneartheopeningoftrading that day when theS&Pstoodnear1,280.

The next day’s headlines

provided more evidence thatabearishstockmarketcrowdhad formed. “Fed, inSurprise,SetsBigRateCuttoEase Markets” read theheadline of the January 23edition of the New YorkTimes. TheChicago Tribunechimed in with its headline:“Fed Jolts Stock Market.”The previous day the U.S.Federal Reserve had cut theovernight lending rate by 75

basispointsfrom4.25percentto3.50percent,andthestockmarket averages hadresponded by rallying fromthe low points they hadreached near the opening oftrading on January 22. TheTimes’ two-column headlinestoodnexttoapairofgraphs,one of which recorded thebehavior of several stockmarket averages the previousday.Italsoappearednexttoa

news analysis by DavidLeonhardt entitled: “WorriesThat theGoodTimesWereaMirage.”Theanalysisopenedwith the sentence: “So, howbadcouldthisget?”

Iftheaggressivecontrariantrader had not alreadyincreased his stock marketallocation to above-normallevels on January 17, hecertainlywouldhavedonesoon January 22 or 23. The

headlinematerialinhismediadiary presented strongevidence for an ongoingbearish information cascade,one that had alreadybuilt upa substantial bearish crowd.The stock market had beendropping for three months,and the Dow and the S&Pshowed their biggestpercentage drops in fiveyears. Moreover, the Fed’sinterestratecutonJanuary22

was in this instance anexample of a crystallizingevent, something that servesto focus emotions in a single(in this case bearish)direction. Such events aregenerally closely associatedwithmarketturningpoints.

Theevidence forabearishstock market crowd becameeven more definitive late inJanuary with the appearanceof several magazine cover

stories. Two that especiallyattracted my attention werethe covers of the February 4issues of BusinessWeek andoftheNewYorker.

The latter was especiallysignificant because the NewYorker is a general interestmagazine that rarely runs acover related to the financialmarkets.ItsFebruary4coverdepicted a worried HumptyDumpty wiping his brow as

he sat atop the New YorkStock Exchange building onWall Street. As we allrememberfromthechildhoodstory, Humpty Dumpty is anegg-shaped fellow whoshattered into innumerabletiny pieces in a great fall,never tobeputbacktogetheragain. From a semiotic pointof view this is a verypowerful and discouragingbearishimage.

The BusinessWeek coverwas less dramatic. Blackletters on a green-lit screenannounced: “MarketReckoning.” The coverdepicted a trader inshirtsleeves, his handsclenched to his head as hestaredattheheadline.

THEBEAR

STEARNSFAILURE

Over the subsequent twomonths the stock marketmoved sideways, notdropping below its Januarylow points but not rallyingmuch, either. The aggressivecontrarian would be waitingfor the S&P to move 1percent above its 50-day

moving average, but this didnot happen before anotherbearish information cascadetook hold. During thiscascade the aggressivecontrarianwouldmaintain anabove-normal stock marketallocation even as the S&Pfell back down to the 1,256levelonMarch17.

In its Saturday,March 17,edition the New York Timesheadline read: “Run on Big

Wall St. Bank Spurs U.S.-Backed Rescue.” The WallStreet bank in question wasBear Stearns. Bear Stearnshad achieved some notorietynine months earlier on June23,2007,whentheNewYorkTimes headlined: “$3.2BillionMovebyBearStearnsto Rescue Fund.” BearStearns found it necessary tobail out a hedge fund it hadsponsored that had gone

belly-up because of lossesfrom mortgage-basedsecurities.

Evidently Bear’s exposureto mortgage losses was evenmore substantial than wasevident in June 2007. TheMarch 17 headline does notmention the stock marketexplicitly and so normallywould not part of a stockmarket information cascade.But I made an exception to

thisruleherefortworeasons.First,theheadlinementionsabank run. This run was notone that affected depositors,but the emotional content isthe same in either case.Worse, it was a Wall Streetbank that needed to berescued. The association ofWall Street with a bank runand a rescue makes thisheadline part of a bearishstock market information

cascade. It provides moreconfirmation that a maturebearish stock market crowdexists.

The Times’ headlines forMarch17andMarch18wereof similar if less dramaticimport. On March 17: “InSweeping Move, Fed BacksBuyout andWall St. Loans.”On March 18: “PlungeAverted, Markets LookAhead Nervously.” These

headlines are all associatedwithacrystallizingevent,therescue (which was in fact agovernment-financed sale) ofBearStearns.

More evidence for amature bearish stock marketcrowd soon followed. TheMarch 22 issue of theEconomist depicted a wallwith a jagged crack runningthrough it. The wall wasembossed with gold lettering

reading “Wall Street.” Thesubheadingread“ATen-PageSpecialReporton theCrisis”in red lettering. Needless tosay, a widely recognizedcrisis on Wall Street isgenerally a good buyingopportunity.

The Weekly Standardchimed in with itsMarch 31issue. This weekly magazineis devoted to conservativepolitics and opinion and

generally does not pay anyattentiontofinancialmarkets.But this particular issue wasan exception. It showed ablack-and-white photographof an olderman dressed in asuit, tie, and hat holding anold-style ticker tape in hishand. The man is frowning,his hat is set back on hishead,andhispalmisslappedagainst his forehead. Thewhole effect evokes

memories of the 1929 crash.The headline simply reads:“YIKES.”

FANNIEANDFREDDIE

From its lowpointonMarch17at1,256intraday,theS&Prallied to a high at 1,440 onMay19.OnApril1 theS&P

closed at the 1,370 level,morethan1percentaboveits50-daymovingaverage.Thissignaled to the aggressivecontrarian that itwas time toagainreducehisstockmarketallocation to below-normallevels.

During April, May, andJune 2008 the stock marketstayedoutoftheheadlinesofmajor newspapers. It wasn’tthe focus of any magazine

cover stories, either.Nonetheless, when I readthrough my media diary forthisperiodIamstruckbythecontinuous flowof badnewsaboutthehousingmarketandtheeconomy.Butperhapsthebiggest single story was thespectacular rise in crude oilprices, from$99onMarch 4to $147 on July 15. This 50percent increase in crude oilpriceswasaccompaniedbya

sharp increase on gasolineprices during the summerdriving season in the UnitedStates. Moreover, this wasonly a part of a generalincrease in the cost of livingfor most Americans. All inall, this was a newsbackground that investorsfoundverydiscouraging.

The June 7 edition of theNew York Times washeadlined: “Jobs Down for

5th Month; Oil’s Rise Addsto Gloom.” Note the use ofthe word gloom in thisheadline, a very strongindicator of the public’smoodatthetime.OnJune24the Conference Boardannounced the June readingof its index of consumerconfidence: 50.4, the lowestreading in 16 years; lowerreadings had been seen onlytwice in the prior 34 years.

Thesetwoitemsillustratethetenor of virtually all mediadiscussion of the state of theeconomy during the April-June period. An enormousbearish economic crowd haddeveloped. Its themes werefalling housing prices, tightcredit conditions, imminentfailures of financialinstitutions, inflation, andincreasing unemployment.Yetthestockmarketwasstill

tradingaboveitsJanuarylowpoint!

TheDowandtheS&P500started another decline fromtheir highs on May 19. Byearly July both indexes haddroppedbelow their January-March lows. Even so, thestockmarketstayedoutoftheheadlines until July 8. Thatday the New York Timesheadlined: “Mortgage FearsDepress Shares at Two

Agencies—FearsofWorsetoCome.” The story concernedthe condition of twogovernment-sponsoredcorporations,FannieMaeandFreddie Mac, bothresponsible for financinghome mortgages for U.S.homeowners. The stockmarket as a whole hadbecome very sensitive to thefortunes of Fannie andFreddie, because their debt

was held by so many banksand financial institutions.FailureofFannieandFreddiewould result in an economy-wide credit crisis andeconomiccontraction.Fromasemiotic point of view thisheadline conveyed extremelybearish sentiments. Note thetwo appearances of thewordfearsandtheuseoftheworddepressandthephraseworsetocome.AweeklateronJuly

15 the New York Timesheadlined: “Confidence Ebbsfor Bank Sector and StocksFall—LinesFormatLender.”The story’s openingparagraph said in part:“[C]onfidence in the bankingsector spiraled downwardMonday.” It went on to notethat the shares of regionalbanks“plunged inoneof thesharpest declines since the1980’s.”

These two headlines, aweek apart, both concernedthestockpricesofbanksandfinancial institutions. Theyindicatedthatabearishcrowdhad developed in this sectorof the stock market. It isimportant to keep in mindthatfinancialinstitutionskeeptheeconomyfunctioning.Inabankingpanicthepricesofallshares, not just those of thebanks, will fall. For this

reasonitseemedtomeatthetime that this was a buyingopportunityfortheaggressivecontrarian trader. This wasanother bearish informationcascade, and on July 14 theS&P had closed at 1,228,which was more than 10percent below its 200-daymoving average and a newlow for the ongoing bearmarket. Here the aggressivecontrarian had ample reason

to increase his stock marketallocation to above-normallevels. Moreover, the S&Phad dropped for about twomonths since its last short-termhighonMay19.

Magazine covers providedmore evidence for theexistence of a bearish stockmarket crowd. The July 7issue of Barron’s washeadlined: “The Bear’sBack.”Itshowedacartoonof

aferocioussnarlingbearwithits teeth bared. The July 14issue of BusinessWeek wasevenmore significant. Itwasheadlined: “RetirementStrategies for Tough Times”and showed a man and awoman trying to find theirway through a maze. Ofcoursethephrasetoughtimesconveys a definite bearishsentiment.Butofmuchmoreimportance is the subject of

the headline, retirement.When contemplatingretirement from theworkforce, people seethemselves as being at themercy of financial marketfluctuations.When they startto worry about retirement, itisgenerallybecausethestockmarket has fallen enough toattract their attention andfocus their fears. Rememberthatthelowofthe2000-2002

bearmarketcoincidedwithaJuly 2002 Time magazinecover story about retirementfears.

The July 19 issue of theEconomisthadon itscoveradepiction of two tornadoes,which were sucking upcurrency, houses, and piggybanks (savings). It washeadlined: “Twin Twisters:FannieMae,FreddieMacandthe Market Chaos.”

Tornadoes represent disaster,and the word chaos is aboutas bearish a word as can beusedtodescribemarkets.TheJuly 28 issue ofBusinessWeek depicted asnake eating its own tail. Itwas headed, in red capitalletters (the color of fear anddanger): “How Wall StreetAtetheEconomy.”

As if to summarizeAmericans’feelingsaboutthe

state of the economy, theEconomist, in its July 26issue, depicted the Statue ofLiberty sitting and staringdejectedly at the New Yorkskyline. The headline read:“UnhappyAmerica.”

Therewerestillothersignsthat an enormous bearishstock market crowd haddeveloped. On August 3 theConferenceBoardreleaseditslatest consumer confidence

report.Forthefirsttimein20years the majority ofrespondents expected stockmarketprices todeclineoverthe subsequent 12 months.The bearish stock marketcrowd was accompanied byan equally bearish economiccrowd. On August 3 theGallup poll showed that 77percent of Americans heldnegative views of theeconomy, while only 7

percentheldpositiveviews!

On August 28 theaggressive contrarian wouldhave seen the S&P close at1,301, for thefirst timesincemid-July at least 1 percentabove its 50-day movingaverage.As it happened, thissignal occurred after theactualshort-termhigh,whichwas on August 11 at the1,305level.Atthisjunctureamovebacktoabelow-normal

stock market allocation wascalled for. It was hard tobelieve then, but worse wasstilltocome.

THECRASH:BANKRUPTCYOF

LEHMANBROTHERS

In September the collapse ofthe Wall Street investmentbanks began and this time aworldwide panic envelopedthe financial markets. Thefirstsignofnewtrouble(anda new bearish informationcascade)was theone-columnheadlineoftheSeptember10edition of the New YorkTimes. It read: “Wall St.’sFearsonLehmanBros.BatterMarkets.”Twodays later the

New York Times published athree-column headline:“Financial Crisis ReshapesWall Street’s Landscape.” Itappeared that LehmanBrotherswason thevergeofbankruptcy. Much to thesurprise of Wall Street andthebankingindustry,theU.S.Treasury and the FederalReserve refused to rescueLehman Brothers and onSeptember 15 the investment

bankenteredbankruptcy.

The Lehman Brothersbankruptcy triggered afinancialpanic.Thesolvencyof virtually every largefinancial institution was nowcalled into question. Thevenerable brokerage firmMerrill Lynch had sufferedsuch losses in mortgage-backed securities that it hadto be sold to Bank ofAmerica. On September 16

we had the first headlinefeaturing stock prices as thesubjectof thesentence.InitsSeptember16editiontheNewYork Times headlined: “WallSt. in Worst Loss Since ’01Despite Reassurances byBush.”ThenextdaytheNewYork Times headlined morebadnews:“Fedin$85BillionBailout Plan of FalteringInsurance Giant.” TheAmerican International

Group (AIG) insurancecompany was in danger ofbankruptcy because of lossesincurred on its issuance ofcredit default derivatives.Finally, onSeptember 18 theNew York Times published afour-column headline: “NewPhase in Finance Crisis AsInvestorsRuntoSafety.”

Note that in only one ofthis sequence of headlineswas the stock market itself

the subject of the headliningsentence. So whereas abearish information cascadewas under way, I think theaggressive contrarian wouldhavehadreason todelayanydecision to increasehisstockmarketexposureeven thoughthe S&P was trading 10percent below its 200-daymoving average. Moreimportant,barelyamonthhadpassed since the last short-

term top on August 11.Generally, buyingopportunities in bearmarketsdeveloponlyafterthemarkethas dropped for at least twomonths.

Duringthenexttwoweeksthe newspapers were filledwith stories and headlinesdescribing the U.S.government’s efforts todevelop a plan for rescuingWallStreetandtheeconomy.

Things came to a head onSeptember 29 when the firstlegislativerescueeffortfailedin the U.S. House ofRepresentatives. The nextday’sheadlinesrecountedtheevent. From the New YorkTimes we have: “DefiantHouseRejectsHugeBailout;Stocks Plunge; Next Step IsUncertain.” The ChicagoTribune that same dayheadlined: “The House Says

No.FearGripsInvestors.”

Clearly a very big bearishstock market crowd haddeveloped, one even biggerthan at the temporary Julylow point. But the S&P wasin a bear market, not a bullmarket. In bear markets,history recommends waitingfor twomonthsor so to passafter a short-term top beforeincreasinglongpositionsinabear market even when a

bearish information cascadehasdevelopedsooner.

The next stock marketheadlines appeared onOctober7, a totalof57daysafter the August 11 short-termtopandcloseenough tothe two-month guideline toget the attention of theaggressive contrarian trader.The New York Timespublished a four-columnheadline, complete with

photographs of fearfulinvestors and charts ofplunging stock prices: “FedWeighsBidtoSpurEconomyAs Markets PlummetWorldwide.” That same daythe Chicago Tribuneheadlined all across its frontpage: “Crisis Goes Global,”and helpfully provided insetphotographs purporting toshow fearful investors invarious world stock markets

accompanied by a downarrow labeled by thatparticular market’spercentage drop the previousday. The Tribune’s biggestcontribution to this bearishinformation cascade camewith its October 10 headlinespread entirely across page 1and accompanied by downarrows describing themarketdrops of the preceding seventrading sessions: “All Signs

Pointing to Panic.”The S&Preached an intraday low at839thatday.

Starting on October 7 theaggressive contrarian wouldhavebeenjustifiedraisinghisstock market allocation toabove-normal levels. TheS&P was trading more than10percentbelow its200-daymoving average. Anunprecedented bearishinformationcascadehadbuilt

up a strong bear marketcrowd. And about twomonths had passed since thelastshort-termtopinthisbearmarket. On October 6 theS&P500closedat1,056,butclosedmuch lowerat996onOctober 7. Nonetheless, Ithinkitisbesttoassumethatthe aggressive contrarianwould have increased hisstock market allocation toabove-normal levels at the

S&P1,056close.

So far I have documentedthe September-Octoberbearish information cascadesolely through newspaperheadlines. But anunprecedented avalanche ofmagazine covers did its partin building up the bearishstockmarketcrowd.Thefirstwas the September 29 coverofTimemagazine.Itdepicteda businessman headfirst in a

hole with only his legsshowing. The caption read:“How Wall Street Sold OutAmerica.”TheSeptember29issueof theWeeklyStandardwas captioned “HighAnxiety”andshowedcartooncharacters fleeing the NewYork Stock Exchange. TheSeptember 29 issue of theNew Yorker showed abusinessman talking on hiscell phone while walking

down Wall Street and aboutto fall into a manhole. TheOctober 13 issue of Timeshowed a Depression-erabreadline and was captioned“TheNewHardTimes.”TheOctober 13 issue of U.S.News & World Reportshowedacartoonofpartofadollar bill with a likeness ofGeorge Washington wide-eyed.Thecaptionread:“HowScaredShouldYouBe?”

Finally, the October 20issue of the New Yorkerfeatured on its cover astunning cartoon of Death,dressed in a red robe andwearing a black-plumed redhat.Hegrippedastaffwithaskull at its top, and held achart on which a jagged redgraph line depicted droppingstockprices.Beneathhisgazestood a group of agonizedbankers and brokers,

apparently bleeding losses inredfromtheireyes.Yikes!Afitting insight into andsummaryofthepsychologicaltenorofthetime!

As I write this, theaggressive contrarian is stillsittingwith theabove-normalstock market allocation heassumed onOctober 7 at theS&P 1,056 level. At itsNovember 20 low close theS&P stood at 752, so he has

suffered through a seven-week, 29 percent drop. Hehas underperformed the buy-and-hold strategy since earlyOctober. But another bearishinformation cascade has nowdeveloped in the New YorkTimes’ headlines. ItsNovember 20 editionheadlined: “Stocks Are Hurtby Latest Fear: DecliningPrices.” This headlineconveyed only mild bearish

sentiment; itcoveredasinglecolumn and used the verbhurt instead of the moreemotional possibilities likeplunge or plummet. A muchmore emotional headlineappeared the following day,though, spread across fourcolumnsandaccompaniedbya chart of the Dow: “StocksDrop Sharply and CreditMarketsSeizeUp.”

As we have seen in this

and previous chapters,headlines like these areusually published within aday or two of a short-termstock market low. For thisreason I think the aggressivecontrarian would now belooking for an upward moveintheS&P.Therealquestionhemustconfront is the tactiche should use to restore hiscurrent stock marketallocation to normal or to

below-normallevels.

NormalbearmarkettacticswoulddemandhewaitfortheS&P to close at least 1percent above its 50-daymoving average and thenrestore a below-normal stockmarketallocation.Butthereisan important issue that theaggressive contrarian mustaddress at this marketjuncture.From itsOctober9,2007, high at 1,565 to its

current 752 low close onNovember 20, the S&P 500hasdropped47percentovera12-month period. The bearmarket has thus far beenabove normal in extent andabout normal in duration.Whataretheoddsthattheupmove from theNovember20lowat752isactuallythefirstleg upward of a new bullmarket?

The strength of bearish

sentiment about the stockmarket and the economyargues for the start of a newbull market from theNovember 20 low. But theaggressive contrariancurrently has an above-normalallocationtothestockmarket and shows asubstantiallossrelativetohisbuyatthe1056levelinearlyOctober. In such situations Ihave always found it best to

“play defense” to avoidlosingtoomuchgroundtothebuy-and-hold strategy. So Ithink the right choice here isto follow the normal bearmarket tactic by waiting foranS&P level closeat least1percent above its 50-daymoving average and thenrestoring a below-normalallocationthestockmarket.

CHAPTER16

VignettesonContrarianThought

andPractice

A 1912 gem •HumphreyNeill • two

great books on tapereading • Neill’scontrary opinionwritings •American’slove opinion polls •Investors Intelligencefills a gap •No FreeLunch • GarfieldDrew and the oddlotter•thefinestbookon speculation everwritten • PaulMontgomery invents

the magazine coverindicator•historiesofbubblesandcrashes •irrational exuberancefinds its nemesis •Robert Shiller • acontrarian looks atvalueinvesting•threepages from the valueinvestor’shandbook

Every contrarian tradereventuallyconstructshisownunique way of taking

advantage of the marketmistakescrowdsmake.Inthepreceding chapters IexplainedthemethodsIhavedeveloped over the past 40years.But there isa lotmoreto say about the contrarianapproach to markets than Ihavediscussed so far. In thischapter I am going to try tofillthisgap.

WhatfollowsisasequenceofshortmemosIhavewritten

for my own benefit over theyearsIhavespentdevelopingmy approach to contrariantrading. These memos werewritten for various reasons.Sometimes I would comeacross a thought-provokingbook andwould thenwrite ashortreviewattemptingtoputit into a broader contextwithin contrarian theory.OccasionallyIwouldlearnofa contrarian method that

wasn’texplainedinanybookIhad readandwouldwriteashort essay explaining itsconnection with my ownapproach. The following areseveral of these vignettes oncontrarian thought andpractice.

THEPSYCHOLOGYOFTHESTOCK

MARKET

The Psychology of the StockMarket is the title of a shortbook written by George C.Selden and first published in1912. It originated from aseries of magazine articlesthathadappearedafewyearsearlier in the Tickermagazine. The Ticker wasfounded by the legendary

RichardD.Wyckoffjustafterthe turn of the century andeventually became theMagazine of Wall Street.Amazinglyenough,thisbookitisstillinprintandavailablefromCosimoClassics.

Selden describes in detailthe ebb and flow of investoremotionsandthinkingduringa typical speculative cycle.His observations are asrelevant today as they were

when first made nearly 100years ago. I was particularlystruck by this passage onpage22:

[M]ost of those whotalk about the marketare more likely to bewrong than right, atleast so far asspeculativefluctuations areconcerned.Thisisnotcomplimentary to the

“molders of publicopinion,”butthemostseasoned newspaperreaders will agreethat it is true. Thedailypressreflects, ina general way, thethoughts of themultitude, and in thestock market themultitude isnecessarily . . . likelyto be bullish at high

prices and bearish atlow.

Here is the genesis of theidea that investment crowds,especially in the stockmarket, can be detected bycarefully tracking thecontentof the media. Over the next100years this ideawould bedevelopedinseveraldifferentdirections, each leading to aparticularmethod for beatingthemarketbyleaningagainst

thecrowd.

THEGODFATHEROFCONTRARY

OPINION

ThetorchlitbyG.C.SeldenwaspassedtothemanIthinkof as the godfather ofcontrary opinion, Humphrey

Bancroft Neill (1895-1977).A wonderful 32-pagebiographyofNeillappearsasChapter 5 in the book FiveEminent Contrarians bySteven L. Mintz, which waspublished in 1994 by theFraser Publishing CompanyofBurlington,Vermont.

Neill wrote three books,eachofwhich is still inprintand remains an outstandingcontribution to contrarian

theoryandtechnique.

The first of these, TapeReading andMarket Tactics,is probably the best singleworkonthetechniqueoftapereading inprint today. Itwasfirst published in 1931. In itNeill explains the methods atape reader uses to evaluateand make deductions fromthe volume of tradingassociated with stock pricemovements. (I should add

that the best work on tapereading ever written isRichard D. Wyckoff’s TapeReading and Active Trading.Thiswaspublishedaspartofhis1930sstockmarketcourseThe Richard D. WyckoffMethod of Trading andInvesting in Stocks. Sadly,this course is no longer inprint. However, one can stillpurchase Wyckoff’s 1910book, Studies in Tape

Reading, which contains hisearly thoughts on tapereading.)

Neill’ssecondbook isTheArt of Contrary Thinking. Itfirst appeared in 1954 and itisstillhismostpopularwork.In its first 46 pages Neillarticulates his theory ofcontraryopinion.Heexplainsitasadialecticalapproachtothinking about markets andmore generally about social

and political affairs. Onestarts from a thesis, which isthe current opinion of thecrowd. The contrary step isthen taken to the antithesis,which is a view in somesubstantial way contrary tothe view held by the crowd.There follows the synthesis,in which one traces out theimplications of facts that thecrowd has overlooked. Thisresultsinanassessmentofthe

extentandwaysinwhichthecrowd’s opinion could provetobemistaken.Inthebook’sfinal 150 pages Neilldevelops his theory in anumber of directions througha sequence of short essays.Stock market investors oftenfindthisbookquirkybecause,while itoffersmuchfoodforthought, it is not focused onthe applications of contraryopiniontoinvesting.

The Ruminator, Neill’sthird book, is of much moreinterest to traders andinvestors. First published in1975,itcontainsanumberofshort essays describing thecontrarian’s take on stockmarket and economic eventsduring the1968-1973period,described by Neill as a timeof great emotional turmoil intheUnited States and aroundtheworld.

OPINIONPOLLS:WHATDOYOU

THINK?

It is interesting to contrastNeill’s approach to contrarythinking to another that hasbecomepopularoverthepast40 years. Neill emphasizedthe importance of assessingthe crowd’s view by culling

information from the printmedia. He often referred tothefileshekeptofnewspaperarticles, magazinecommentary, brokerage firmrecommendations, and thelike.ItisNeill’sapproachforgathering information that Ihavetakeninthisbook.

But it wasn’t long beforethe opinion poll supplantedNeill’s method for assessingthebeliefsofthecrowd.This

development may reflect apeculiarly American trait. Inhis1936classic,TheGeneralTheory of Employment,Interest, and Money, JohnMaynard Keynes observed(sectionVIofChapter12):

Even outside the fieldof finance, Americansare apt to be undulyinterested indiscovering what theaverage opinion

believes the averageopiniontobe;andthisnational weaknessfindsitsnemesisinthestockmarket.

In 1963 an Americanadvisory firm, InvestorsIntelligence, led by itsfoundingeditorA.W.Cohen,began a weekly polling ofnewsletter writers and otherinvestment advisers abouttheir current stock market

views. The results weresummarized by thepercentages of advisers whowere thenbullish,bearish,orneutral on the stock market.The Investors Intelligencepoll has had many imitators.Some of these have focusedon the futures markets.Another is a weekly pollsponsored by the AmericanAssociation of IndividualInvestors.This isa surveyof

its members, a much biggerswath of nonprofessionalinvestors, and has beenconductedatleastsince1987.

Opinion polls like thesehavea45-yearhistory.Therewas a timewhen I paid a lotofattentiontothesepolls.ButI grew disenchanted withthem.Ifoundthatindicationsof an ongoing informationcascade were far moresignificant than are the

opinions of investmentprofessionals offered on aweekly basis. Moreover, theresults of these weekly pollsare highly correlated withshorter-term movements inthe stock market itself,showing high bullishsentiment after an extendedrise in the averages and highbearish sentiment after anextendeddrop.Consequently,there are no set levels of

bullish or bearish sentimentthatgive reliableclues to themarket’s subsequentmovements.

This is not surprising.These polls are all in thepublic domain. Theymake iteasy to be a contrarian by,say, turning bullish when 50percent or more of thosepolledexpressbearishviews.But the No Free Lunchprinciple implies that such a

strategy cannot beat themarket, because it usesinformationthatmustalreadybe incorporated into thecurrentlevelofstockprices.

Why doesn’t the sameargument imply that thecontrarian trader’s mediadiary will similarly beuseless? The No Free Lunchprinciple tells us that anysuccessful contrarian tradingstrategymustuseinformation

that is outside the public’spurview. Now, it is true thatall the content recorded in acontrarian’smediadiaryis inthe public domain. But thediary itself is not! Thetrader’s selection of contentto retain in his diary willreflect his grasp of the lifecycles of investment crowdsand his understanding of thetypes of opinions that revealan ongoing information

cascade. The semioticinterpretation a skilledcontrarianmakesofhisdiarymaterial will develop hisinsight into the nature andintensity of an investmentcrowd’s beliefs.A contrariantrader’s media diary thusbecomes a highlypersonalized tool for beatingthemarketandassuchisnotinformation available to theinvestingpublic.

Is there any danger thatmedia diaries will becomepopularamonginvestorswhofancy themselves contrariantraders?Ithinknot.First,itisalotofworktomaintainsuchadiary.Second,actingontheinformation contained inone’s media diary meansinvesting againstwidely heldpopular beliefs, somethingbeyond the capacity of mostinvestors. This is the source

of the contrarian trader’sedge.

ISTHEODDLOTTERALWAYS

WRONG?

In1941thefirsteditionofthebookNewMethods forProfitin the Stock Market was

published.Itsauthor,GarfieldA. Drew, was asked at thetime why he would write abook about stock marketprofits when there were noprofits tobehad in the stockmarket.Drew simply smiled,for he knew that his odd lotindexes were sending adifferent message. The DowJonesIndustrialAveragethenwas trading near the 105level, down from its 1929

peak at 381, which hadoccurred12yearsearlier.The1929 crash and the GreatDepression of the 1930s hadsouredthenationonthestockmarket. Yet the April 1942low in the Dow JonesIndustrial Average at the 92level was then just a fewmonths away, and thisaveragehasneveragainbeenthat low at any time duringthesubsequent67years!

Drew himself was acommitted contrarian at atime when the theory ofcontrary opinion didn’t evenhave a name. The revised1955 edition of his book sitson my shelf and is of greatinterest to anyone curiousabout the historicaldevelopmentofNeill’stheoryof contrary opinion. Itssection VI, entitled“Measures of Psychology,”

takesup68ofthebook’s383pages. In this section Drewexplains Neill’s work on thetheory of contrarian opinionand illustrates its use in thestockmarketduringthe1936-1948 period. Drew alsoexplains his particularimplementation of Neill’stheory, his famous odd lotindexes.

Oddlotsareordersforlessthan100shares (around lot)

and customarily did notappear on the New YorkStock Exchange ticker tape.The ticker tape was a paper-based, telegraphic reportingmethodfor transactions(laterwas supplanted by the so-called Trans Lux, anelectronic version of thepaper tape that used to bedisplayed in all brokerageoffices). Nowadays reportingis done electronically on all

individual stocks, and nohuman being could possiblyprocessthetorrentoftradesifpresented to him in thesequence in which theyoccurred.

In any case, when Drewdevelopedhisoddlotindexesit was widely believed thatpeoplewhotradedinoddlotswere ill-informed and mostprone to be trading onemotionsinsteadofeconomic

fundamentals.But in the late1930s the BrookingsInstitution published a studyofodd lotbehaviorasshownbymonthly transaction totalsover the 1920-1938 period.Thisstudyconcludedthatoddlot transactions tended tomove toward buying onbalance as stock pricesdeclined and toward sellingonbalanceas theyadvanced.Contrary to the popular

conception, odd lottersseemedtoactmorerationallythan the investment adviserspollednowadaysbyInvestorsIntelligence:Theygrewmorebullishaspricesdroppedandlessbullishastheyadvanced!

ButDrew had noticed twosubtle features that he feltcouldbeused toquantify thethen conventional wisdomabout odd lot behavior.Neartheextremesofpriceswings,

oddlotterswouldtemporarilytake leave of their senses!Just before low pointsoccurred, theodd lotterswhohad been steadily increasingtheir ratio of purchases tosales would temporarily takefright—one would thenobserveatemporarydecreasein their purchase-sale ratio.Justbeforehighpoints in theaverages, the oppositephenomenon could be

observed. Drew also notedthat the number of odd lotshort saleswouldoften showdramatic and suddenincreases near low points ofpriceswings,behavior that issimilar to thebehaviorof thebearish sentiment percentageininvestorpollsnowadays.

Drew’s odd lot indexesrepresented a significantadvance in the theory ofcontraryopinion.Forthefirst

time an objectivemeasure ofthe market sentiment of aspecific segment of theinvestor population, the oddlotters, had been constructed.This was possible becausethere was no need for thenumber of shares purchasedin odd lots to equal thenumber of shares sold.Drewapplied his theory withgenerally good forecastingresults until the end of the

1960s.Ofcourse,hisodd lotindexesneededagreatdealofinterpretative skill onDrew’sparttobeeffective.

But in 1973 stock markettradingchangeddramatically.The Chicago Board OptionsExchange was establishedand spurred the developmentof exchange trading in putand call options. Now asignificantpartofthevolumeof trading on the stock

exchanges and optionsexchangesarose fromhedgesand spreads, transactions inwhich traders attempted toprofit frommispricing of putand call options. Thepurchaseof a call option canbe seen as a bet that a stockwillriseinprice,whereasthepurchase of a put option canbe seen as a bet on a pricedecline. This was both goodnews and bad news for

contrarians.

Thebadnewswas that theadvent of exchange-tradedput and call options affectedthe amount of and themotivation for odd lottrading. Where odd lottransactions had previouslybeen investment choices ofsmall investors, now theyincluded a large number oftransactions thatwerepartofhedges involving put or call

options. At this juncture theodd lot indexes quickly lostmostof theirvalueasmarketcluesforthecontrarian.

The good news was thatnow there was a newopportunity to observe theopinions of investors asreflectedintheactivityofputand call options traded onoptions exchanges. Thetheory was that near marketlows the ratio of put volume

tocallvolumeshouldbehighand the converse shouldoccurnearmarkethighs.Thisput-call ratio has manyvariants, but they all showstrong (negative) correlationwith the levels of the stockmarket averages, just as dothe opinion survey numbers.Moreover, the volume of putand call trading isinformation that is freelyavailable to the public.

Consequently, the No FreeLunch principle tells us thatthese put-call ratios will notbe good predictors ofsubsequent pricemovements.Ibelievethat thisimplicationhas been supported by theevidence.

AFORECASTINGGIANTOFTHE

PAST

The finest book onspeculation ever written isInvestment for Appreciationby Lawrence Lee BazleyAngas. First published in1936, it describes Angas’stheory of the business cycleand the steps investors maytake to profit from theassociated swings in the

prices of stocks, bonds, andcommodities.

Angas himself developedan extraordinary forecastingrecord during the 1920-1940period, when he wasinvariably right about stockprice movements in Englandand the United States andtheir associated economicfluctuations.Inhislateryearshisforecastingrecordbecamemore erratic. Angas perished

inahotelfirein1972.Abriefbiographyof theman can befound included in thebiographyofNeill(Chapter5inFiveEminentContrarians)cited earlier in this chapter.As it happened, Neill andAngas had developed afriendship, and in the early1950sNeillpersuadedAngastomovetoNeill’shometownof Saxton’s River inVermont.

While it would not do tocallAngasacontrariantrader,even a casual reading of hisbook reveals a man whobelieved that investmentsuccess only comes to thosewho are willing and able tocrossthecrowd,tobuywheninvestors are temporarilydiscouragedand to sellwhenthey are enthusiastic. Angasadvocated an investmentpolicysimilartotheonethatI

have suggested for theaggressive contrarian trader—take advantage of shorter-term upswings anddownswingsthatoccurinthecontext of bull and bearmarkets. In his book Angasalsodiscussedtheartofchartreadingandadvocateditsusein conjunction with hiseconomictheories.Infact,heassertedthatchartreadingbyitself was slightly more

effective as an investmenttool than economics usedalone! In any case, a carefullook at his chart readingtheoryshowsthatithasmuchin common with the markettabulations I have discussedinChapter6ofthisbook.

PAULMONTGOMERY,

THEMAGAZINECOVER

CONTRARIAN

Paul Macrae Montgomery isthe most innovative thinkertheworldofcontraryopinionhasseeninthepast40years.ItwasfromMontgomerythatI learned the importance ofmagazine cover stories for

detecting informationcascades and the associatedinvestment crowds. In themid-1970s Montgomerystudied the Time magazinearchivecontaining thecoversof all its issues from1923 tothe present. He found thatthose covers that had somesortoffinancialmarketthemeoftenpointed toan imminenttop or bottom either in thestock market averages or in

the stock of some specificcompanyorindustrygroup.

The general rule hededuced was that bullish oroptimistic covers or covershighlighting the success of aprominent CEO or financiergenerally preceded thedevelopment of an importanttop within the four monthssubsequenttothecoverstory.Conversely, covers thatconveyed a pessimistic

attitudeorfearaboutfinancialaffairsor thathighlighted thefailure of some prominentfinancier’s policy precededthe development of animportant low point within amonth.

The passing years havebeen very kind toMontgomery’s magazinecover theory. As an activemoney manager and marketcommentator, he has used it

to make spectacular marketcalls over the past 30 years.Montgomery stands withNeill,Drew,andA.W.Cohen(the founder of InvestorsIntelligence) as a guidinglightforallcontrariantraders.

IRRATIONALEXUBERANCEANDOTHER

BUBBLES

Bubbles and the crashes thatinevitably follow arefrequently revived dramasplayed on the stage of freemarkets.Theyarethegreatestopportunity and at the sametimethegreatestdangertothecontrariantrader.InthisbookI have tried to show howmonitoring the progress of

information cascades canalert the investor to theexistence of investmentcrowds whose growth anddisintegration cause bubblesand crashes. And I haveshown how to use simpletactics utilizing movingaverages of the S&P 500 totime portfolio adjustmentssuggestedbytheexistenceofthesecascades.

But the essential nature of

any market economy isdescribed by JosephSchumpeter’s wonderfulphrase, creative destruction.Theonlythingwecanbesureof is that financial marketsand the media will beorganizeddifferently50yearsfromnowthantheyaretoday.The basic principles ofcontrarian trading will notchange during the next 50years, if ever. They are

timeless and rooted in thenature of free markets. Butthe specific sourcesofmediacontent and possibly also thenature and identity of themarkets most prone tobubblesandcrashesprobablywill evolve in unexpectedways.

Tocopewithandadjust tochanging conditions, thecontrarian tradermusthaveagood grasp of the way

bubbles andcrashes typicallydevelop, a grasp that isattainedbystudyinghistoricalinstances of thesephenomena. Of course it isbetter to have lived throughandinvestedduringthem,buteven then a historicalperspective reveals detailsand relationships that areobscureatthetimeeventsareunfolding.

I thinkagoodway tostart

this project is by reading abook entitledDevil Take theHindmost by EdwardChancellor, subtitled AHistory of FinancialSpeculation. This waspublished in 2000 by thePenguinGroup.Sadly, itwaswritten before the stockmarket bubble of 1994-2000burst,althoughitdoescontainsome last-minute commentsonthisepisodeonpages150-

151,at theendof thesectiondevoted to the railwaymaniaof the 1830s in England!Amongthisbook’shighlightsisalongchapterontheboomin the Japanese economyduring the 1980s and on thesubsequentbust.

One of my favorite booksis one by David N. Dreman,published in 1977 andentitled Psychology and theStock Market. Dreman has

since become a well-knownand very successful moneymanager and value investor.Healsohaswrittenanumberof other books, but I thinkthis one is his best. In itDreman explains how WallStreet groupthink feeds stockmarket bubbles and why noinvestment professional isimmune to its effects. Heillustrates his thesis withdetailedhistoricalaccountsof

a number of bubbles and avery close look at the U.S.stock market during the1960s and early 1970s,especially the Nifty Fifty,two-tiered stock market of1972.

The 1994-2000 stockmarket bubble in the UnitedStates and the subsequentbear market are coverednicely in a book by MaggieMahar, published in 2003 by

HarperCollins and entitledBull!WhileIlikethisbook,Ithink it is necessarilyincomplete as a historicaldocument since it waspublished so soon after thebubble burst. Perhapssomeoneisevennowatworkonadefinitivehistoryof thatbubble.

Charles P. Kindleberger(1910-2003) was an eminenteconomic historian. Perhaps

hismost popularwork is thebook Manias, Panics, andCrashes, which was firstpublished in 1978 and mostrecently in a revised 2005edition. In this bookKindleberger not onlyrecounts the facts detailinghistorical episodes of marketmanias and crashes, but alsoexplains his views on theirunderlyingcausesandon theappropriate responses

governments should make tothese phenomena. This isdeeper water than theprevious three books I havementioned,butthereaderwillbe repaid for his effort tonavigate in and out of itsmany historical bays andinlets.

The economist and authorwith the best literary markettiming is without doubtRobert J. Shiller. In March

2000, the exact peak of the1994-2000 stock marketbubble, his book IrrationalExuberancewaspublishedbyPrincetonUniversityPress.InitShillerarguedthatonlytheirrational exuberance ofinvestors could explain theunreasonably high stockmarket valuations thencurrent.Hewentontopredictan imminent return to morenormal valuations and an

attendant substantial drop instock prices. It should bepointed out that the phraseirrational exuberance firstentered the publicconsciousness when AlanGreenspan, the chairman ofthe Federal Reserve, used itin a speech in 1996. It wasShiller who had suggestedthisphrasetoGreenspanasadescription of the stockmarket psychology of that

time.

Shiller then repeated thiscoup of precise publicationtiminginthe2005revisionofthis book,which included anexpandedlookatandanalysisof the bubble in housingprices. The following yearsaw the peak in housingprices in the United States,and the collapse of this realestate bubble eventuallybroughtonthecrashof2008.

In2008ShillerpublishedTheSubprime Solution, in whichhepresentshisanalysisofthecollapsing real estate bubbleand suggests solutions formanagingthecrisis.

I believe that everycontrarian should read andrereadbothofthesebooks.Inthem Shiller offers a wealthof information on historicalbubbles in stocks and realestate, as well as detailed

explanations for thepsychological mechanismsthatcausethem.Therecanbeno doubt that Shiller is theworld’s reigning expert onthe formation of investmentcrowds, the theme of thebookyouarereading.

VALUEINVESTING—A

BACK-OF-THE-ENVELOPEAPPROACH

It may seem strange toincludeashortessayonvalueinvesting in a book aboutspeculation. But I think amoment’s reflection showsthat there is a closeconnection between value

investingand thegrowthanddisintegration of investmentcrowds. Warren Buffett, themost successful valueinvestor of all time, puts itbest when he says that thetime to sell is when peopleare greedy, and the time tobuy iswhen they are fearful.Investmentcrowds,especiallybearish ones, createopportunities for valueinvestors as well as for

contrarian traders. So itmakes sense that indicatorsthat help value investorsdetermine whether the stockmarketisfaroverorfarunderfair valuewouldbeuseful tothecontrariantrader,too.

A value investor does notpaymuch attention to crowdpsychology. Instead, andabove all else, a committedvalue investor wants to forma reliable estimate of a

business’s fair value. Thisgenerally means trying todeterminetherateofreturnitearns on its invested capital,andwhetherthisrateofreturncan be sustained and/orimproved. A value investorwants to hold shares incompanies that earn thehighestrateofreturnontheirinvestedcapital, for thesearealmost by definition the bestbusinesses in the economy.

Note that the rate of returnearned on invested capitalmay differ from the rate ofreturn on shareholder equity,because of debt financing.Avalue investor is generallymuch more concerned aboutthe former than about thelatter, even though both domatter.

Having identified suitablebusinesses using the rate ofreturnoncapitalcriterion,the

value investor then concernshimself with the price atwhich shares in the businesscanbepurchased.Itisatthisjuncture that value investingbecomes as much art asscience. What is a fair pricefor the equity in a goodbusiness? There is nodefinitive answer to thisquestion.Onegenerallyseeksguidance from the historicaldata on valuations of similar

companies to estimate somenormalrangeoffairpricesfora business with similarcharacteristics. Intuition,togetherwithbusinessvision,generally plays an importantrole,too,asdoesanabilitytoevaluate whether corporatemanagement is committed tomaintainingandimprovingitsrate of return on investedcapital.

The formal aspects of this

process,thosethathavetodowith balance sheets andincome statements, areexplained thoroughly in theinvestment classic SecurityAnalysis by BenjaminGraham and David Dodd.Thisbookwasfirstpublishedin1934andisstillinprintinrevised editions. BenjaminGraham is widelyacknowledgedasthefatherofvalue investing and was

Warren Buffett’s mentor. Heis credited with articulatingthe concept of themargin ofsafety, which describes thesituation inwhich themarketprice for a security issufficiently below its fairvalue that unforeseen eventswill not cause loss to theinvestor.

An excellent introductionto Benjamin Graham’sthinking can be found in his

bookTheIntelligentInvestor,which was first published in1949.Ihighlyrecommendthe2006 paperback edition(HarperCollins) containingcommentary by Jason Zweigas well as a preface andappendix by Warren Buffett.The story of how Graham’sthinking influenced BuffettandoftheinnovationsBuffettmadesecurityanalysisistoldexpertly in a wonderful

biography, Buffett: TheMaking of an AmericanCapitalist, by RogerLowenstein (Random House,1995).

Is it easier to be a valueinvestor than a contrariantrader? In a word, no. Bothneedtheabilitytostandasidefrom the crowd’s influence,to buy when others arefearful, and to sell whenothersarecheerful.Thevalue

investor’s skill in assessingthe likelihood that therateofreturn on capital will stayhighorimproveusesinsightsthat are difficult to teach.Similarly, the contrariantrader’s skill in cullingsuitable media content thataccurately reflects the tenoror the time is built onlythrough experience. Bothtypes of investors can carveprofitable niches into the

slippery slope of theinvestment mountain. But inneither case is this processeasyorsimple.

I’d like to offer theinterested contrarian threemethods that help valueinvestorsdetectextremeover-orundervaluationinthestockmarket.Thesetoolsneedonlythebackofahandyenvelopefor calculations. In fact, ifyoumakeuseofyourfavorite

Internet search engine, youwon’tevenneedanenvelope.The calculations I am abouttodescribeareoftendonebydedicated investors whomaintain blogs or homepages, andyouwill probablybeabletopiggybackyourselfontheirwork.

Ishouldsaythatyouwon’tbe able to become asuccessful value investorusing only these simple

methods. They speak onlyrarely.Butwhentheydotheyidentify situations in whichinvestment crowds havepushed stock marketvaluations so high or so lowthat the correct long-terminvesting stance becomesobvious. This can be veryvaluable information to acontrariantraderaswell.

The first method issimplicity itself. Just

calculate the current valueofcommon stocks of publiclytraded U.S. corporations anddivide this number by thedollarvalueofgrossdomesticproduct (GDP). This stockmarket/GDP ratio fluctuatesabove and below its averagevalue of 0.6. In 1929 and1972, two instances ofextreme overvaluation, thisratiostoodat0.8orhigher.In1932 and 1942, both

instances of extremeundervaluation, the ratiostood at 0.2. In 1974 and1982theratiodroppedalittlebelow 0.4, showing anundervalued condition thatwas not as extreme as thatassociated with the GreatDepression. At the peak ofthe 1994-2000 stock marketbubble the ratio reached 1.7.My rough calculation showsthattheratiostoodnear0.6in

late November 2008, at itshistorical norm and notshowingclearundervaluation.

The second method issimilarinspirit tothefirst.Itinvolves calculating Tobin’sq ratio. If you want to learnmore about Tobin’s q, Isuggest you read ValuingWall Street by AndrewSmithersandStephenWright,abookfirstpublishedin2000byMcGraw-Hill.Tobin’sqis

the ratio of themarket valueof common stocks to thereplacement value of thecapital employed by theassociated corporations. Thisismore difficult to calculate,buttherawdataarepublishedby various governmentagencies. Values of qsubstantially above 1.0indicate an overvalued stockmarket, while valuessubstantially below 1.0

indicateanundervaluedstockmarket. At the peak of the1994-2000bubble theq ratiostoodatarecordhighof2.9.Iestimate that on November20, 2008, with the S&P 500closing at 752, the q ratiostoodat0.65.Whileitwouldneed to fall to 0.5 to matchtheundervaluationlevelsseenin 1932, 1974, and 1982, theratio indicated that the U.S.stock market was

substantially undervalued inlateNovember2008.

The third method wasadvocated by BenjaminGraham and popularized inShiller’s book IrrationalExuberance. It is the classicprice-earnings ratio for theS&P 500, but one that usesthe 10-year moving averageof reported earnings as thedenominator. The averagevalue of this ratio during the

past120yearshasbeen16.Itgenerally drops below 10during times of significantundervaluation. By contrast,at the 1929 peak this ratiowasover30,andat the2000bubble top it stood at ahistorical high of 44. At theNovember 20, 2008, S&Plowof752thisprice-earningsratio stood at 11,well belowits historical average but notyetbelow10.

Thesethreepagesfromthevalue investor’s handbookwillhelpthecontrariantraderidentify the bullish crowdsthat create stock marketbubblesaswellasthebearishcrowds that seem willing togive away their stockmarketholdingsforasong.Back-of-the-envelopecalculationslikethiswon’tmakeyouthenextWarrenBuffett,but theywillhelp you to avoid the

mistakes that make stockmarket investing sofrustratingforsomany.

AbouttheAuthor

Carl Futia is a stock indexfutures traderwithmore than25 years of experience. Aneconomistwith a Ph.D. fromtheUniversityofCaliforniaatBerkeley, he also haspublished a number ofarticles in academic journals.

Hecurrentlywritesoneofthemost popular investmentblogsontheInternet.

Index

Above-averagereturnsAcampora,RalphAdvances in BehavioralFinance (Thaler andBarbaris)AgricultureAIG. See AmericanInternationalGroup

Al-QaedaAmazon.comAmerican Association ofIndividualInvestorsAmerican InternationalGroup(AIG)AmericaOnline(AOL)Angas,LawrenceLeeBazleyAOL.SeeAmericaOnlineAppleComputerTheArtofContraryThinking(Neill)Assets

BandwagonstrategyBankruptcyBarbaris,NicholasBarone,MichaelBarron’sBartiromo,MariaBearmarket1921-19291942-19661976-19781982-20002000-2002

aggressive contrariantradingduring2000-2002collapse of the bubble,2000-2002crowdendofextendednormaltacticsduringthe2001plungerebalancing during 2000-2002marketshortS&Lcrisisand

transition to a new bullmarketBearStearnsBehavioralfinanceexploitable market mistakesandpredictionsBernanke, Ben S.. See alsoVolcker,PaulBezos,JeffBiggs,BartonBikhchandani,SushilBlackGold

Blodget,HenryBlogsBloombergBondmarketinterestratemovementsandmortgagebackedsecuritiesBrimelow,PeterBrowning,E.S.Bubbles1994-20001995-20002000-2002collapse

developmenthistoryhousingmarketspeakoilpostbubble bull market of2002-2007Buffett: The Making of anAmerican Capitalist(Lowenstein)Bull!(Mahar)Bullmarket1982-2000

1991-19941995-2000200520062007earlylateaggressive contrariantrading in the 2002-2007market1990bearmarketcrowdand1929-1932crash1987crash

declineofdurationinformationcascadeandlong-term capitalmanagement1990lowpanicof2008andpostbubble during 2002-20071987-1990S&Lcrisistransition from a bearmarketBusinessWeek

Byron,Christopher

CapitalgainstaxesCapitalmanagementCara,BillCase-Shiller housing priceindexCDs. See Certificates ofdepositCertificatesofdeposit(CDs)Chancellor,EdwardChartStore

ChicagoBoardofTradeChicago Board OptionsExchangeChicagoTribuneCivilWarClinton,PresidentBillCNBCCohen,A.W.Cohen,AbbyJosephCollateralized debtobligationsCollective wisdomequilibrium

CommoditiesCommoditySystemsInc.CommunicationmassmediaandContrariantraderaggressionandduring the 2000-2002 bearmarketcapitalgainstaxes1987crashandcreditcrisisanddifficultybeingedgeand

goalsinvestmentplanninginvestmentportfoliomistakesnoviceduringthepanicof2008strategiesbandwagoninvestmentwithacrowdlong-onlyrebalancingspeculation

thoughtsandpracticevisionofCreditTheCrowd(LeBon)Crowds. See also Socialgroupsbehaviorofinvestmentcollectivejudgmentcollectivewisdomforecasting marketpsychologyindependentdecisionsinthefinancialmarkets

marketmembersspeculationandCubanmissilecrisis

Debt-deflationDellComputerDemuth,PhilDevil Take the Hindmost(Chancellor)Discountedfuturedividends

DividendsDodd,DavidDot-comcompaniesbubbleof1994-2000Dow Jones IndustrialAverageDreman,DavidN.Drew,GarfieldA.Druckenmiller,StanleyDudack,Gail

EarningseBayEconomicsconsiderations foruncoveringmistakesglobalizationneweconomyEconomistEdgeofthecontrariantraderEFTs. See Exchange-tradedfundsElvesIndex

EmploymentratesEnronEquilibriumpriceEuropeanWarExchange-traded funds(ETFs)Eyeballcount

FairvaluepriceversusmistakesFama,Eugene

FannieMaeFinancialInstitutionsReform,Recovery, and EnforcementActof1989Financialmarketscrisesandcrowdsindependentdecisionssubprimecrisesof2008FinancialReviewFive Eminent Contrarians(Mintz)Ford,BillFordMotorCompany

ForecastingFortuneFranklinNationalBankFreddieMacFundamentalistinvestors

GaleofcreativedestructionGDP. See Gross domesticproductGenentechGeneralMotorsCorporation

The General Theory ofEmployment, Interest, andMoney(Keynes)Gladwell,MalcomGlobalizationGoldGoogleinitialpublicofferingGraham,BenjaminGranville,JoeGreenspan,AlanGross,DanielGross domestic product

(GDP)Grubman,JackGulfWar

Harper’sHaugen,RobertA.HedgefundsHedgehogging(Biggs)Hirshleifer,DavidHousing bubble. See alsoMortgages

Hulbert,MarkHulbertFinancialDigestHussein,Saddam

IBMInflationInformationcascadesbehavior of investmentcrowdseffectonmarketinformationtechnology

investorsandaslivinghistorymediaandnewinformationeconomysequenceofchoicessignsofabullishmarketInitialpublicoffering(IPO)GoogleInstinctsoftheHerdinPeaceandWar(Trotter)IntelThe Intelligent Investor(Graham)

InterestratesbondmarketandcutsInternetInvestmentcrowdsbearmarketof2001-2002communicationcontrariantradingandeyeballcountfinancialcrisesandhistory of bubbles andcrashesidentificationof

informationtransmittedinstincts and the search forcertaintylifecycleandpsychologyofbirthanddeathcyclelifewithinmassmediaandmatureinvestmentandmentalunityofmistakesversusfairvaluemonitoringthemarketsnewinformationeconomy

personalflexibilityandpiedpipersofrecognizingstock market bubble of1994-2000suggestibility,volatility,anddisintegrationtoleranceInvestment for Appreciation(Angas)InvestmentgoalsInvestmentplanningInvestmentportfolio

InvestmentthemeInvestorsbehaviorexposurefundamentalistinformationcascadesandsocialgroupsandvalueInvestorsIntelligenceIPO. See Initial publicofferingIraqIrrational Exuberance

(Shiller)

James,WilliamJapanJobs,SteveJournalofPoliticalEconomyJPMorganChase

Keynes,JohnMaynardKindleberger, Charles P.

Knight,FrankKoreanWar

LeBon,GustavLegislation. See FinancialInstitutions Reform,Recovery, and EnforcementActof1989LehmanBrothersLendersoflastresortLincoln,PresidentAbrahamLong-onlystrategy

Long Term CapitalManagement(LTCM)crisisof1998“A LongWayDown” (SteinandDemuth)Lowenstein,RogerLTCM. See Long TermCapitalManagementLucentTechnologies

Magazinecoversstories

MagazineofWallStreetMahar,MaggieMaineMalkiel,BurtonManias,Panics,andCrashes(Kindleberger)MarketdatacreativedestructionmarketsemioticsmonitoringsourcesMarket-investment-themedsocialgroups

effect by informationcascadeMarketVolatility(Shiller)MarketWatchMassmediafutureofinvestmentcrowdsandMCIWorldComMedia diary. See alsoindividualnewspapersin2002in2005in2006

constructionedgemagazinecoversandmarketsemioticsnewspapersnovicesandpurposestockmarketandtotrackinvestmentthemesweightoftheevidenceMeeker,MaryMicrosoft

Mintz,StevenL.Mistakescreationversusfairvaluehistoricalcontextidentificationmarketdatasourcesstatisticallyexploitableundervaluation in the stockmarketMoneymarketfundsMontgomery,PaulMacraeMoody’sInvestorsService

Morgan,JohnPierpontMorgenson,GretchenMorristownDailyRecordMortgagebackedsecuritiesMortgages.Seealso Housingbubble during the panic of2008

NASDAQCompositeindexNeill,HumphreyBancroftNewCenturyFinancial

NewMethodsforProfitintheStockMarket(Drew)NewRepublicNewspaper headlines . SeealsoindividualnewspapersNewsweekNewYorkerNewYorkmagazineNewYorkTimesNewYorkTimesMagazineNikkeistockmarketNixon,PresidentRichardNoFreeLunchPrinciple

OilinflationpricesprognosisOpinionpollsOracle

Panicof2008SeealsoFannieMae;FreddieMacBearStearnsandbullmarketand

conservative contrarianduringcreditcrisisanddebt-deflationspiralLehmanBrothersandlendersoflastresortmortgagesandPapertradingPC.SeePersonalcomputerPeakoilinvestmentsPennCentralCorporationPennSquareBankPersonalcomputer(PC)

Politics, effect of war andinternational political crisesstockmarketPriceline.comPrinciples of Psychology(James)ProfitsPsychologyofaninvestmentcrowdPsychology and the StockMarket(Dreman)The Psychology of the StockMarket(Selden)

Publishingindustry

QratioQuantumFundQuattrone,FrankQwestCommunications

RailroadsRational expectationsequilibrium

RationalexpectationstheoryRebalancingduring 2000-2002 bearmarketduringthecrashRetirementRisk, Uncertainty, and Profit(Knight)Riskslunaticfactor“thelastonetoknow”unknownunknownRobertson,Julian

Rukeyser,LouisTheRuminator(Neill)Russia

Samuelson,RobertJ.SaudiArabiaSchiller,RobertJ.Schumpeter,JosephSecurity Analysis (GrahamandDodd)Selden,GeorgeC.

Semiotics.SeealsoMagazinecoversdefinitionofeventsfront page stories andeditorialsmarketnewspaperheadlinespricechartS.G.WarburgShiller,RobertJ.SiliconGraphicsSIV. See Specialized

InvestmentVehicleSloan,AllanSmithers,AndrewSocial groups. See alsoCrowds“blackhole,”collectivebehavioreccentricpeopleininvestmentthemesandmembershipinSPDRs. See Standard &Poor’sDepositaryReceiptsSpecialized Investment

Vehicle(SIV)SpeculationStandardOilStandard&Poor’sDepositaryReceipts(SPDRs)Standard&Poor’s(S&P)500indexStatistically exploitablemistakesStein,BenStockCharts.comStockmarketduring2000-2002

bearmarketin2000-2002boomin1996-2000bubbleof1994-2000bullmarketin1921-1929in1949-1966in1994-2000crashesdisintegrationin2003effect of war andinternational political crisesonefficientmarkets

evidenceexposurefluctuationsinstockpricesindustrygroupsmediadiaryandmistakesNoFreeLunchPrincipleovervaluationpanicof2008psychologyrisksrollercoastersand

speculationtimingundervaluationunstablenatureofStudies in Tape Reading(Wyckoff)The Subprime Solution(Shiller)Surowiecki,James

Tape Reading and ActiveTrading(Wyckhoff)

Tape Reading and MarketTactics(Neill)Taxes,capitalgainsandTechnologyTerrorismThaler,Richard“A Theory of Fads, Fashion,Custom,andCulturalChangeas Information Cascades”(Bikhchandani, Hirshleifer,andWelch)TickerTigerManagement

TimeTheTippingPoint(Gladwell)Tobin,JamesTonightShowwithJayLenoTreasurybondsTrotter,Wilfred

U.S.CongressU.S.FederalReserveratecutU.S.News&WorldReport

ValuingWallStreet(SmithersandWright)VietnamWarVolcker, Paul. See alsoBernanke,Ben

WallStreetJournalWallStreetWeekWar,effectofpolitical crisesonstockmarketWatergatescandalWeeklyStandard

Welchi,IvoWilson,PresidentWoodrowThe Wisdom of Crowds(Surowiecki)WorldComWorldWarIIWright,StephenWyckhoff,RichardD.

Yahoo!Yahoo!Finance

Zweig,Jason