Contrarian Investing Made Easy (1 Tool to Use)

By TradeSmith Editorial Staff

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“The time to buy is when there’s blood in the streets.”

That quote, credited to Nathan Mayer Rothschild, is used when referring to a contrarian investing strategy.

If everyone is panic selling, it can be incredibly profitable to go against the grain and buy shares of companies at what could be incredible discounts.

With fears of a recession on the horizon, this quote, and the idea behind it of being a contrarian investor, is as timely as ever.

But before we get too much far into contrarian investing, I want to share a brief background on the Rothschild dynasty so you can understand the life-changing wealth that can be created by going against what everyone else is doing.

A Dynasty Worth $500 Billion

Since 1811, the Rothschilds have succeeded in London banking (today the family is worth an estimated $500 billion), making their early fortune in government bonds and bullion. But Nathan Rothschild also pioneered alternative methods for income creation, uncovering an opportunity to profit from the Napoleonic wars.

Supporting the Duke of Wellington, he loaned money to English troops in their efforts against Napoleon. The Rothschilds naturally made money as debts were repaid, but they also speculated heavily on the stock market.

As Napoleon fatefully confronted the English armies at Waterloo, Nathan played his advantage. This was a time before the internet, the telephone, or even the telegraph.

Through Nathan’s network of suppliers and agents across Europe, he was able to receive advance notice that Napoleon had been defeated.

Realizing he was in possession of information that no one else had, Nathan famously sold heavily on the market. And as other investors took note, they followed, driving the market down.

Nathan then went back into the market and quietly bought up almost the entire stock market at severely discounted prices. Then, as the news made its way across Europe, investors came back in and the market skyrocketed, generating an even greater fortune for the Rothschilds.

The accuracy of the exact details of this story aside… Nathan Rothschild’s strategy has been encapsulated by the saying “buy on the sound of cannons, sell on the sound of trumpets,” and it fully embodies the spirit of contrarian investing.

Going Against the Grain

At its root, contrarian investing is a financial philosophy in which enthusiasts buck prevailing market trends, selling when others are buying and buying when many investors are selling.

If a contrarian believes everyone is buying and stocks are overvalued, they may look for opportunities to short stocks or sit on the sidelines with a pile of cash.

When stocks go back down in price and appear oversold, the contrarian uses that cash pile they were sitting on and buys stocks at a discount to where they were previously trading. The philosophy is simple enough, but one of the biggest challenges of following a contrarian investment strategy is the enormous research involved in evaluating a stock’s fundamentals and accurately gauging investor sentiment.

There are a number of tools that you could use to help your decision-making process, but I’m going to focus on just one right now…

The Fear & Greed Index

For investors looking for clues about possible entry and exit points, the Fear & Greed Index helps pinpoint extremes that signal tops and bottoms. It accomplishes this by gauging market sentiment, or how bullish or bearish investors are feeling at any given point.

The Fear & Greed Index distills the prevailing sentiment into one of five designations:

  • Extreme Fear
  • Fear
  • Neutral
  • Greed
  • Extreme Greed

The TradeSmith Fear & Greed Index is accessible from the Dashboard in our Trade360 program.

To get a handle on where the market is heading, the index uses seven benchmark measurements.

  • Junk-bond demand – Measures the popularity of lower-quality high-yield bonds. When investors are greedy, they tend to seek higher yields, regardless of risk. However, when the tide turns, their fear drives them toward safer investments.
  • Market momentum – Reveals how much the S&P 500 is trending above or below its 125-day moving average. Fearful investors start selling off, sending the S&P 500 into a downtrend, which may cause it to break below its 125-day moving average. The exact opposite occurs when investors are greedy.
  • Market volatility – Tracks the latest price of the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX. This index measures the expected price fluctuations, or volatility, over the next 30 days and is a very useful gauge of fear and market sentiment. High readings in the VIX are generally associated with high levels of fear in the market.
  • Safe-haven demand – Compares the recent performance of stocks to that of U.S. Treasury Bonds. Fearful investors, feeling bearish, often gravitate toward the relative safety of bonds. Selling stocks to buy bonds causes bonds to outperform. However, greedy investors, feeling bullish, accept bigger risks on stocks with higher potential payoffs.
  • Stock price breadth – Measures the difference between advancing and declining volume in stocks listed on the NYSE. A higher volume of declining stocks is an indication of more fearful investors. If it reaches an extreme, it can signal a bottom. However, an extreme in higher volumes of advancing stocks may indicate a market peak.
  • Stock price strength – Compares the difference in the number of stocks making one-year price highs to the number of stocks making new one-year price lows. Fearful investors tend to generate more one-year price lows. Extremes in this measurement may signal a market bottom.
  • Put and call options – Compares the trading volume of bearish put options and bullish call options. More put options are bought by fearful investors, causing this ratio to rise; greedy investors buying a majority of call options causes this ratio to fall.

How Contrarian Investors Use These Metrics to Their Advantage

Each of these metrics moves the needle closer to the Extreme Fear or the Extreme Greed end.

The contrarian makes investment decisions based on the opposite of herd mentality. Therefore, if the Fear & Greed Index is indicating Extreme Fear, that’s the same as investors calling for a downturn, and contrarians know to swoop in and snatch up stocks at a discount. It’s time to buy.

If the needle is pointing to Extreme Greed, the likelihood is that the market is overbought, and the contrarian begins unloading. It’s time to sell.

This natural ebb and flow between fear and greed is part of the life cycle of stocks. And our Fear & Greed Index can help you ride the waves of investor sentiment toward better returns.

What stocks are you buying now using a contrarian investing strategy? Let me know right here.