The Theory of Contrary Opinion - What it is and how to use it

February 23, 2021 15:00 UTC
Reading time: 17 minutes

What is contrarian investing? Have you ever heard someone say, “When those who aren’t involved with the stock market are talking stocks, it’s time to sell”? This famous phrase is an example of contrarian investing and how to apply the theory of contrary opinion to the world of trading.

 

What is the theory of contrary opinion?

The theory of contrary opinion, otherwise known as contrarian investing, is a psychological theory applied to trading, according to which, when most people have the same opinion about what the market is going to do, there is a high probability that it moves in the opposite direction to that expected by that mass of people.

In other words, the theory of contrary opinion in trading tries to anticipate a change in the trend in the price of a financial asset, even though market sentiment or technical and/or fundamental indicators indicate a contrary position.

Due to the characteristics of trading, this change of direction will be more intense at the beginning of the movement. Traders usually limit losses by placing a stop loss. Therefore, when there is a change in trend, these orders begin to jump and a domino effect occurs that sinks or triggers the value of the financial asset.

Consequently, the potential loss if the trend continues is small compared to the potential benefit of speculating on a possible change in direction.

Is the theory of contrary opinion rational?

Trading is complicated by nature. Psychology is only one of the aspects that can influence operations. About 3 out of 4 small investors lose money with their trading. Someone might think that if a small investor wants to make a profit from trading, then according to the theory of contrary opinion, all they have to do is trade in the opposite direction as most of the market. However, that logic does not always lead to the desired results.

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Is the theory of contrary opinion economical?

Let’s look at the economic forces that may be at play behind the theory of contrary opinion. These are economic factors that a contrarian investor may pay attention to.x Under competitive conditions, the price of any asset will be determined by its supply and demand.

Source: Personal elaboration. Done: January 20, 2021

In this example, this market will be in equilibrium for a certain price and quantity.

What will happen if the price of this asset rises and the rest of the factors remain constant?

Under this assumption, the market will go out of equilibrium and the corrective forces will tend to restore the initial equilibrium.

Source: Personal elaboration. Done: January 20, 2021

As the price rises, there will be many more producers who want to sell their product but very few interested buyers. This will create an excess supply and producers will have to reduce the price of the asset to sell that surplus.

How will this new price be kept in equilibrium?

It will be necessary to move the supply or demand curves.

What usually happens in reality?

The number of investors in the market usually increases, shifting the demand curve to the right. These new participants enter the market attracted by the positive expectations of this financial asset and are characterized by having less experience in the sector.

Purchases by these new investors push the asset price higher and improve returns for investors already in the market. This process tends to accentuate over time. The euphoria often moves from financial markets to the media. Everyone expects to have benefits. Here is where we can see the events predicted by the theory of contrary opinion unfold. 

Source: Personal elaboration. Done: January 20, 2021

Experienced traders find that these assets have lost their appeal as they offer increasingly worse returns on investment. Doubts begin to arise and these traders change their position from bullish to bearish producing a fall in the price of the asset.

This fall causes losses in the majority of small investors who had opted for the opposite effect and uncertainty begins to take over the market. Fear, being a very volatile sentiment, spreads like wildfire, and the market changes its position quickly.

In general, the price of the asset after the fall does not usually return to the initial point, since there are more participants in the market who have been trapped and are confident that the price will recover.

These are some of the economic influences behind the events sometimes predicted by the theory of contrary opinion. 

Can the theory of contrary opinion be proven?

There are associations that collect market sentiment. One of the most recognized is the American Association of Individual Investors (AAII). This association conducts a weekly survey among its members, where they are asked if they believe that the S&P500 will rise, fall or remain stable in the next 6 months.

With such market data, we can assess whether the changes in the market can be described by the theory of contrary opinion.

How can you avoid getting trapped?

How do you know if the theory of contrary opinion will correctly predict the movements in the market, the price will drop, and you’ll get trapped?

Several leading indicators can be used as signals for these possible changes. Some of the most prominent are:

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How to apply the theory of contrary opinion in a real market?

A practical example of applying the theory of contrary opinion can be found in the recent evolution of the price of silver against the US dollar.

A material that, according to the market consensus, is in an upward trend since its demand is increasing and its supply is decreasing.

Increasing demand (moving to the right) pushes prices up. This is caused by several factors, including:

  • The characteristics of silver as a refuge value, are making its demand increase in the face of the advance of the coronavirus after the Christmas holidays.
  • Silver is an essential element in the production process of the so-called “green revolution”.

Additionally, it is expected that its supply will be reduced (shift to the left) due to the reduction in the production of this material, which will also push prices up.

Source: Personal elaboration. Done: January 20, 2021

How high will the price of silver rise?

The theory of contrary opinion states that if the majority of the market expects an asset to appreciate, the chances of the opposite happening increase. This is what happened.

In the graph below we can see the upward trend of silver since the beginning of December 2020. However, since the middle of the month and, despite the good prospects for the metal, the increases in its price are increasingly small. This causes some experienced traders to change their position.

Source: XAGUSD daily chart from Admiral Markets MetaTrader 5 platform (from November 11, 2020, to January 20, 2021). Completed: January 20, 2021. Note: Past performance is not a reliable indicator of future results or future performance.

Evolution in the past 5 years:

  • 2020: 47.66%
  • 2019: 15.20%
  • 2018: -8.58%
  • 2017: 6.34%
  • 2016: 15.08%

If you want to follow these examples, download Metatrader 5 for free.

After a first breakout attempt on January 6, fear increases in the market and traders begin to change their position from bullish to bearish, producing a steep fall on January 8, 2021.

As can be seen in the image, the price of silver doesn’t return to its initial position as many traders have been trapped and are confident in the recovery of the asset price.

In order to take advantage of this change in trend, we can use the signals emitted by the RSI indicator. When this indicator exceeds the 70 point barrier, the asset is considered to be overbought and, if the majority of people buy an asset expecting an increase in its value, this increases the chances that a correction will occur, as the theory of contrary opinion predicts.

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Theory of contrary opinion - Contrarian investing ideas

#1: Emerging Markets

Valuation metrics aren’t perfect, but the United States stock market is considered expensive by almost every metric:

  • U.S. price-to-earnings ratio: historically high
  • Price-to-book ratio: historically high
  • CAPE: historically high
  • Dividend yield: historically low. 

We’re currently almost 10 years into the United States’ second-longest expansion in its history.

Additionally, the U.S. has been outperforming most markets throughout the past ten years. This isn’t a contrarian environment.

On the other hand, many international stocks, particularly in emerging markets, have been performing poorly in the past decade.

If the dollar changes direction and makes a substantial down move, then some of the emerging markets might be some of the best beneficiaries in this environment.

In 2020, the dollar index fell below its 50-month moving average and it has been starting to point down. If it continues, we could see the third major decline of the dollar in the last 50 years of the modern global monetary system.

Chart Source: StockCharts.com

It’s too early to make any prediction with certainty, but emerging markets will be worth paying attention to in the next 5-10 years, mainly due to their mean-reversion and a potentially weakening U.S. dollar. 

Most of these markets are currently trading at low valuations and have higher growth potential than some developed markets.

#2: Undervalued sectors in the U.S. in 2021

While we are talking about the US, let’s look at some sectors within this country that have been downtrodden while others have risen. 

Generally speaking, the world has been in a period in which growth stocks have outperformed value stocks. This is also true for the United States:

Chart Source: Vanguard

In particular, commodities and their producers have been at historic lows, unlike the S&P 500. Such opportunities arise only once every several decades:

Chart Source: Incrementum

So, what are the best contrarian stocks to buy now? This might give us an idea. 

While low-volatility and technology stocks, including utilities and consumer staples, have been performing well lately and are currently above average valuations, many cheap stocks in underperforming sectors are currently trading at below average valuations: 

  • Commodity producers
  • Retailers
  • Consumer discretionary companies
  • Industrials
  • Midstream companies
  • Asset managers

These, among others, have generally been beaten down.

Many of them have poor performing share prices for a reason - they have existential problems. However, as most investors these days trade ETFs, they are neglecting entire sectors and industries at a time, instead of analysing and selecting individual stocks, like a contrarian investor might do. 

Therefore, within the beaten-down sectors of 2021, some stocks may have potential - we could consider these our contrarian stock picks. These are high-quality companies that have been grouped in with poorly performing peers in challenging sectors.

Let’s look at some examples of companies that may be overvalued, undervalued, or performing as expected:

Apple (AAPL)

The Apple stock price went parabolic in 2020, even as the fundamentals stayed normal (it may be overvalued).

Amgen (AMGN) 

The Amgen stock price has followed the fundamentals to (likely neither overvalued nor undervalued).

Enterprise Products Partners (EPD) 

The Enterprise Products Partners’ share price crashed in 2020, despite its fundamentals remaining relatively flat (it may be undervalued).

When stocks are overvalued or undervalued, a rotation and reversion is possible. However, it’s too early to make any predictions with certainty. No decisions should be made now, but we can keep an eye on this. 

It’s possible 2021 could see some rotation. We may be able to determine what the best contrarian stocks for 2021 are. However, we can’t be certain - there are fiscal and political factors that will influence the performance of these sectors as well, making it challenging to make contrarian stock picks. 

In any case, diversity in a traders portfolio is one aspect of risk-management strategy that can help when contrarian stock investing. 

Moreover, education and a well-rounded risk-management strategy are essential for any trader to minimize the risk of losses they can’t afford when contrarian value investing or investing with any other strategy and sector.

Final Words

Some contrarian investors commonly move funds gradually from overvalued sectors into undervalued sectors.

One way to do this is to buy and sell stocks in the most common way. Of course, there are more elegant ways to invest as well. However, to add more security to their trading strategy, some traders avoid short positions, limit their use of margin, avoid investing in high-debt companies and primarily invest in companies with long-term competitive advantages.

You can use general market valuation metrics, such as the Shiller PE ratio, to help develop a rough understanding of how overvalued a market is relative to its 150 years of historical data.

Traders can use this data to help identify some contrarian investing stocks, which portion of their portfolio to allocate to equities in the market they’re analysing, as well as international markets worth prioritizing. This applies to both index investors and those who select individual stocks.

Are you ready to try investing in contrarian stocks, but aren’t ready to risk your money? You can experience trading contrarian stocks in a real trading environment without risking any money with a free demo account from Admiral Markets. Sign up here:

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