It is important to remember that the basic thesis of the contrarian investor is one of buying and selling exhaustion. The market tends to drop when there’s nobody left to buy and rise when there’s nobody left to sell at a given point. This is not to be confused with sentiment, although sentiment is often a good indicator of where people have their money. If I’m bullish on Apple, I’ve probably already got my money in AAPL. However, if someone keeps giving me money, I still have the ability to buy more Apple stock. Because I am bullish, I am even willing to pay a higher price, and I contribute (in a small way) to continued price increase. At the sentiment extreme you will see the steepest price increases because for every buyer there must be a seller, but nobody wants to be a seller because they are bullish. They want to hold on, until the premium offered makes it worth their while. After they part with their Apple stock, they are not likely going to jump back in right away. They effectively remove themselves from the market, at least temporarily. That is when the biggest decline occurs, destroying the gains from the steep increase near the end and then some.
I say this because I am extremely bearish right now. However, I am holding a position that is considered market neutral. Yesterday’s end of day selloff was the price action that many were looking for to call a top. If those traders moved to a negative position, they face losses that would force them to become buyers, contributing to more increase. Everyone knows that market timing is a sucker’s game. It’s dumb luck to get out at the right time. Getting out early hurts, but getting out late hurts a lot more. Making wrong way bets is the same as getting out late. I am holding an options position, which by its very nature is a bet on timing. Considering that this bet currently has me down half a month’s income in one month’s time, I’m well aware of the risks of market timing. I fortunately entered the position with winnings, so I’m not terribly loss averse here. Yet I am afraid enough of a melt-up to avoid setting up huge bets to the downside. When I make day trades, I only trade on days that look like they will end up. All my day trades are upside bets. When the market starts tanking and re-establishes a downtrend, my day trades will all be downside bets. All of my weekend-spanning swing trades are strangles or straddles (market neutral bets on big moves in either direction).
The point of this is that gauging sentiment and gauging position are two different things, and sometimes contrarian investors forget that.
Having said that, I still think this is a bear market rally, so I wouldn’t recommend looking for an overly-bullish top anyway. I would either look at technical reasons for a top or look to see if traders suddenly start caring about fundamentals again. The market close yesterday looked jittery to me. I expect jittery markets to move rapidly, but I expect the direction on a daily basis to roughly mimic a random walk. Since the short term trend appears to be up, I still anticipate a positive bias. If that manifests as a blow-off top, I’ll be happy. If the top already occurred, I’ll be happy provided that the trend change is brutal.
