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Markets

These 2 Tried-and-True Contrarian Measures Say "Time to Buy"

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In recent weeks I've been focusing on the myriad buying opportunities that have been uncovered as the market grinds ever lower. Am I being naive? Am I being a mere cheerleader for the financial establishment? Not hardly. I just know investors should question the bulls when optimism is rampant and tune out the noise when pessimism reaches a fever pitch.

And I know this from experience. In the past 20 years, I've often seen stocks move precisely in the opposite direction from what the herd seemed to anticipate. I wrote about this topic last summer , when individual investors were fretting that stocks were about to plunge. Back then, I noted that when "stocks are hated" by individual investors, they tend to rise in value. Professional investors are also misguided when it comes to anticipating the market's next move correctly, as I'll explain in a minute...

Individual investors

When the American Association of Individual Investors finds that 25% or less of investors feel bullish , as measured by a weekly survey, you should be prepared to buy. For instance, stocks began to wobble in late July, but investors felt like hanging in there, expecting the market decline to be short-lived. Two months later, they're throwing in the towel -- better known in the trading world as " capitulation ."

Below you'll see the results of AAII's latest weekly survey. As you can see, just 25% of individual investors are now bullish.

This strategy seems virtually foolproof. Here's why...

Even when investor sentiment appeared to break down in 2008 and bearish sentiment yielded negative near-term returns, longer-term returns still bounced back to break even. Overall, by using this strategy, investors made an average three-year gain of 34.5%, even after including the paltry three-year returns in 2008. Using the two-year return (which includes the results from the dip in sentiment seen in March 2009), investors who pursued this strategy yielded an average return of 26.8%.

Patience is a virtue with this investment approach. Contrarian investing in 1993 initially looked mistaken, only yielding a 5% return a year later. But patient investors ultimately bagged a 47% return in three years. And in the last two times bullish sentiment dipped below 25% -- in 2009 and 2010 -- investors needed to wait at least six months before they were able to snag double-digit gains. If investors had failed to lock in gains after six months from August 2010, when bullish sentiment last dropped below 25%, they would have been exposed to the subsequent market pullback this summer. Therefore, this isn't a buy-and-hold strategy. Indeed, any sort of major rally off of these lows would push me pretty quickly into the bear camp for a simple reason: We now live in world of rapidly-changing optimism and pessimism, so it's important to stay on the opposite side of the fence in most cases.

Professional investors

Many professional investors use options as part of their investment approach, which can bring even higher returns than stocks but also takes an advanced level of analysis not suitable for individual investors. And just like the other approach for individual investors, the pros can mess up as well, turning far too pessimistic right before a rally ensues. The key determinant is the Chicago Board of Options Exchange's ( CBOE ) Put/Call ratio . Whenever investors buy a lot more calls, they are bullish. Conversely, whenever they buy a lot more puts, they are bearish. [I encourage you to click on the links for puts and calls if you want to know more. Our friends at InvestingAnswers.com do a great job of explaining these concepts.]

The reading is typically below 1.0, implying an emphasis on calls over puts. Yet right now, the reading has been above 1.0 on almost every trading session going back to July 27. That's an unprecedented streak of bearishness: the ratio has rarely been above 0.8 for such an extended period of time, going back to 2003 (which is as far back as the CBOE's data go).

-- David Sterman

As chart above shows, bearishness has been rampant lately, which is in fact a bullish sign. In most instances when the put/call ratio moves well above 1.0, as it has on a number of recent occasions, the market tends to post at least a strong short-term rally within a few weeks.

Risks to Consider: As is the case with any technical measurements of the stock market, future results don't always follow the script. Fundamental drivers, such as the upcoming earnings season , will also have a lot to do in determining the market's next move.

Action to Take--> Many investors remain gun-shy about jumping into the market and are loathe to committing more funds to stocks. At a minimum, this analysis should tell you this is a lousy time to sell, even if this is what your gut tells you. Trusting your gut -- and not your head -- has proven to be the wrong move for individual and professional investors many times in the past. And history is likely going to repeat itself.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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