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Madness in the markets means contrarians are flourishing now

TO MANY an investor&rsquo;s surprise, the FTSE 100 hit its highest level since the start of the year yesterday while the Dow surpassed the 9,000 mark just over a week ago and is still trading a comfortable couple of hundred points above it. But over the past fortnight, some sceptical analysts have described the rally as faith-based, overextended and unsustainable. In their view, the markets have been driven higher by investors&rsquo; collective belief that stocks ought to rise, rather than a particularly outstanding bag of earnings results and economic data. It&rsquo;s an old story. Crowd momentum is all too often what fuels prices to surge or plunge, rather than any rational decision on behalf of individual investors.<br /><br />In the short-term, contracts for difference (CFDs) traders often look to take advantage of the crowd momentum by backing the direction of the trend as this allows them to capture some profit. But all too frequently, they jump on the tail end of a market move &ndash; at best, they capture a smaller amount of profit than they might have been hoping for. At worst, they lose substantial sums as the market turns against them.<br /><br />In certain circumstances it is clearly ideal to follow the crowd &ndash; nobody in their right mind would have gone long on the FTSE 100 the day that Lehman Brothers collapsed. The million-dollar question for traders is, when do you follow the crowd and when do you decide that it is wrong? <br /><br /><strong>INVESTMENT CROWDS</strong><br />This issue of crowd behaviour is one of the things that Carl Futia addresses in his new book, The Art of Contrarian Trading: How to Profit from Crowd Behaviour in the Financial Markets. He argues that investment crowds are born from the human desire to be part of a successful and prominent group, and investment crowds are even more compelling because they promise members above-average returns similar to those achieved by existing participants.<br /><br />It is at this point that the crowd grows to a point at which its size creates a market mistake and members of an investment crowd may appear not to be acting in their own personal interests. The pressures to conform to group behaviour may well overwhelm individuals&rsquo; capacity for rational calculation, explains Futia.<br /><br />Certainly, crowds can have collective wisdom but this usually results in the stock hovering at or around fair value. It is when the price is substantially above or below this level that irrational behaviour sets in. This can create an &ldquo;information cascade&rdquo; &ndash; whereby an individual imitates the behaviour of others without regard to his own information &ndash; which also helps to reinforce investors&rsquo; beliefs and attract new members into the crowd. &ldquo;The constant repetition of a crowd&rsquo;s investment theme is the single most important characteristic of life within an investment crowd,&rdquo; writes Futia. &ldquo;All one hears is a repetition of the investment theme and confident pronouncements about profits to be earned by its followers.&rdquo; But these information cascades are very fragile, he adds, because &ldquo;a very little information held by a few individuals right at the start of the cascade induces a great number of individuals to abandon their own collectively more substantial information&rdquo;.<br /><strong><br />GENERAL CONSENSUS</strong><br />The danger, of course, is that you get carried with the crowd when you shouldn&rsquo;t be. And that is where contrarian trading comes in. For Futia, that doesn&rsquo;t mean always dissenting from the general consensus and avoiding investment crowds.<br /><br />Indeed, he sees the advantages in trading along with the crowd, provided you have a healthy sense of realism. It&rsquo;s about knowing when to get out. &ldquo;As the crowd grows, it makes sense to invest in harmony with the crowd&rsquo;s investment theme. But eventually the crowd grows so large that it forces the market price well past fair value. At this point the investor either needs to step aside from the crowd&rsquo;s investment or even invest in an opposite theme,&rdquo; he notes.<br /><br />In order to be profitable, the successful contrarian trader must be able to consistently identify investment crowds and their investment themes and be able to make rational deductions from these observations and then translate them into trading.<br /><br />So how do you identify market mistakes made by investment crowds? The key, says Futia, is to look at it in the context of the market&rsquo;s historical fluctuations. You can look at where the asset is relative to its historical highs and lows and for individual stocks, look at its price/earnings ratio relative to its historical average and to its peers. (See charts.)<br /><br />Contrarian trading is not a silver bullet. It involves legwork and research. As a contrarian CFD trader believing a stock to be overvalued you would wait for the crowd behaviour to gain momentum and the asset to start rising in price before going short (or, of course, the opposite if you think a stock is undervalued). This strategy means that you will see a greater points fall in the stock and thus more profit.<br /><br />However, since this might mean that your money will be sitting on the sidelines waiting for the momentum to fizzle out, you could look to nip in and out of the rising stock using spread bets to capitalise on the crowd momentum as well.<br /><br />This longer time-frame and need for a bigger cushion of money in your account means that contrarian trading is well suited to CFD traders compared to, say, spread betters, who are looking almost exclusively to capitalise on market momentum in either direction.<br /><br />This could be is particularly interesting at the moment, when there is uncertainty about recovery in the markets. Many analysts are suggesting that current optimism is overstated and that &ldquo;not-as-bad-as-expected&rdquo; news can only masquerade as good news for so long. This could be just the moment for a spot of profitable contrarianism.<br /><br />The Art of Contrarian Trading is out later this month, published by Wiley. RRP: &pound;42.50