Introduction

Contrarian investing generates stunning returns with minimal risk - providing it is timely! However, as many investors know, applying the concept of contrarian investing into the real world is easier said than done. Therefore, at 3boXreversaL we devised a stock market indicator, the ContraGauge. As a result, fluid, and competent, market timing is achievable.

ContraGauge

Our market timing indicator consists of over 100 variables; measuring stock market sentiment and technicals. The algorithm is computed at the end of each stock market trading session to produce a reading of between 0 and 360 degrees.

Contrarian gauge output is interpreted in a similar way to traditional technical oscillators. Generally, ranging from 90 degrees through to 270 degrees, the former reflects fear, the latter indicative of a greed extreme. Aside from detecting major market bottoms and tops, the ContraGauge also acts as a guide to the investor at all other times. Readings above 180 degrees reflect a bull market cycle. Beneath 180 degrees, a bear market. As a result, the investor is able to position their portfolio appropriately.

ContraGauge readings are analyzed in our weekly contrarian report. Published pre-market open each Monday.

What is a Contrarian?

Contrarian refers to a speculator who takes a trading position in the opposing direction to the majority. The trader is classified as a speculator since their action is perceived as risky. The contrarian goes against the grain, repressing their natural herd mentality.

When the crowd has bought and are fully committed, the contrarian's investment strategy is to sell, or go short. When the crowd is selling enmasse, the strategy of contrarian investing would encompass buying.

However, contrarian investing must be timely. The crowd can hold market direction for a prolonged, and illogical, period of time. Therefore, the contrarian will need to execute their opposing strategy to the moment when all who can believe, are fully committed position wise. A contrarian who enters their strategy prematurely will invariably be stampeded by the herd.

To execute effective market timing, we used our decades of stock market sentiment and technical analysis experience, to develop a tool, the ContraGauge.

Contrarian acts against the crowd.

Essentially, our contrarian gauge is a stock market indicator that enforces systematic market timing. ContraGauge computes the market technical condition plus stock market emotion. In part, an evolution from traditional measures of stock market sentiment, such as the Investors Intelligence Advisors Sentiment Survey or the AAII Sentiment Survey.

What is Market Timing?

Market timing refers to entry and exit, to and from, the stock market, in an efficient manner. Buying at the lows. Selling at the highs.

Impeccable market timing is the most powerful trait of the skilled contrarian. The contrarian acts against prevailing stock market sentiment. If premature, the market punishes the contrarian.

Stock Market Indicator Explained

ContraGauge quantifies emotion of the market, euphoria to fear, and everything in between.

The gauge identifies periods when an investor should break away from the crowd and adopt a contrarian investment strategy.

Our contrarian gauge enables more accurate, and effective, broad market timing.

Master Indicator

Watching multiple screens and technical indicators all day long is laborious, time consuming and unnecessary. Furthermore, it confuses. Lesser indicators also often contradict each other. However, our contrarian gauge captures what matters. In brief, 101 market sensitive variables in an algorithm, generating a simple reading from 0 to 360 degrees. Stock market sentiment and technical health form the backbone of ContraGauge.

Contrarian Gauge value range
Contrarian Gauge Summary

ContraGauge is represented by a simple pie diagram. Readings run clockwise from 0 to 360 degrees. Back testing has enabled various wedge-like sectors to be identified. For instance, a trending bull market will see readings swing back-and-forth within the 210 to 240 degree section. Whereas, a bull market peak will see readings of around 270 degrees. Alternatively, a bear market bottom would experience sub 100 degree readings.

Relevance of 180 Degrees

Simply, 180 degrees is the dividing line between a bear market and a bull market.

  • Therefore, above 180 degrees, an investor should be predominantly long the market, in outperformers. That is, until a market top presents, as indicated by the stock market indicator.
  • Beneath 180 degrees an investor should be either, mostly in cash or short underperformers. Until such a time as a bottom is flashed by the gauge. Market bottoms always turn a lot faster than a top.

Contrarian Investing using the ContraGauge

How to identify the start of a Bull Market?

When the ContraGauge rises from a bear market bottom reading (90 degree region) and breaks up through 180 degrees,  confirmation of a bull market is served.

The upside break through, and above 180, on a sustained basis, over at least three weeks, eliminates the possibility that the rally is a bear market dead-cat.

Case Study

S&P 500 example from 2019. Late 2018 saw a brief bear market. The start of 2019 saw a recovery by the stock market indicator, from a deep fear situation, a reading of around 100 degrees. The contrarian gauge moved back above 180 degrees by the second half of January 2019 and held. Consequently, a fresh bull market confirmed. Contrarian investing achieved! November 2019, ten months later, Wall Street had still not accepted the bull market and yet the market was hitting record highs. Likewise, stock market sentiment showed no enthusiasm for the rally. Typically, the crowd needs a prolonged period of time to reverse their view.

Contrarian Investing from a bear market to a bull market example.

ContraGauge provides the signal ahead of acceptance by Wall Street and the public. Thereby, enabling one to be invested at a more favorable level before the crowd catches on.

When to buy a Bull Market correction?

ContraGauge has been designed to enable efficient market timing with regards entering a bull market correction. Invariably, investors struggle to time entry on a correction. Either, buying too early and experiencing losses, or too late, missing the boat completely.

During a healthy bull market correction, our stock market indicator typically retreats to the 180 degree region. Once at neutral, a base builds. A subsequent sharp reversal up signals the correction is complete.

Case Study - Reversal from 180 degrees

The summer of 2017 through to the end of 2019 saw three S&P 500 pull-backs successfully captured by ContraGauge. The three periods are highlighted on the chart below. With each case, investors are doubting the bull market and wrongly positioning their portfolios for a bear market. However, our stock market indicator implied otherwise, basing across the 180 degree region, followed by a sharp snap-back.

The contrarian indicator has ample upside room as it rises from 180 degrees. Stock market sentiment is not lofty. Technicals are comfortable. Thus, a plain sailing advance by the S&P 500, to new record highs, is the natural course.

Using stock market indicator to capture optimum stock market sentiment level for buying.
How to identify a Bull Market top?

ContraGauge warns of a bull market top when readings visit the 250 through to 270 degree region. Over the past twenty years, we have observed this behaviour on the vast majority of significant tops. Once the indicator enters that band, investors need to be on their guard, sandbagging their equity portfolios. However, entering the overbought zone is not an immediate sell signal.

A bull market peak confirms when the ContraGauge breaks down sharply, back down through the 250 level. The greed bubble deflates fast. Defensive measures are rapidly called for. Additionally, short positions in underperformers may also be considered, riding the correction south.

Case Study - Overbought Extreme

November 2017 through January 2018 saw the ContraGauge swing back and forth, within the 250 to 270 degree band. The U.S. equity rally appeared relentless at the time. Investors were optimistic. Stock market sentiment showed excessive bullishness. However, at the end of January 2018, the indicator abruptly broke lower, signalling a stock market peak.

Case Study - Overbought plus Bearish Indicator Divergence

September 2018 saw a further market top, a brief break by the S&P 500 above the peak of eight months prior. ContraGauge briefly entered the 250 to 270 band, but a lower indicator high to that from the start of 2018. Consequently, when the contrarian gauge dived back down through 250 degrees, a bearish divergence printed. That divergence signalled the market was in more trouble than it had been eight months previously. In turn, a deeper correction followed. New index lows eighteen months later.

Case study of ContraGauge forecasting a bull market peak.
How to identify the start of a Bear Market?

When our contrarian stock market indicator fails to find support from 180 degrees a bear market is signalled. The signal is a leading indicator. A bear market condition is known long before acceptance on Wall Street and Main Street. Therefore, when the ContraGauge holds beneath 180 degrees, investor portfolios should be positioned for a falling market.

During a bear market, a high cash position is ideal, or in the very least, a strongly defensive portfolio. Nimble traders could also take advantage of downside opportunities by shorting vulnerable stocks.

The ContraGauge falling through 180 degrees indicates structural damage to the market. The damage is beyond that which occurs on a healthy bull market correction. Consequently, time is needed for the market to heal. Conditions nearly always get worse, via technical carnage and fear, before the rebuild commences.

Case Study - Bear Market Entry

Early October 2018 saw the ContraGauge dive through 180 degrees. Subsequently, the indicator traded sideways, banging its head on 180 degrees. Resistance cemented. The market struggled to heal. Early December 2018, the contrarian indicator broke lower aggressively, confirming bear market status. However, the bear market itself was brief, so short that few even acknowledged its existence. Bear markets may see durations of a single session to a number of years.

Market Timing exampe - Our stock market indicator signals a bear market.
How to spot a Bear Market dead-cat?

Dead-cat rallies, from false bear market bottoms, are natural and frequent. A head-fake bounce is reflected by the ContraGauge rising into the 180 degree band, followed by a turn back down. The roll over signals insufficient repairs have been made to the market internally. Additionally, sentiment has not deteriorated sufficiently to enable a bull market. The equity market will need to weaken again, a further shake-out. Eventually, the new shoots of a fresh bull market emerge.

Basically, the bear market dead-cat is the opposite of the bull market correction. As discussed above, in a bull market pull-back, our stock market indicator retreats down to 180 degrees, reverses, with the bull market springing back.

Case Study - dead cat rally

A series of bear market dead-cats were reflected by the sideways action beneath 180 degrees, over October and November 2018. Each time a dead-cat terminated, our stock market indicator rolled over from 180 degrees.

How to identify a Bear Market bottom?

ContraGauge readings of between 90 and 100 degrees are typically seen at a bear market bottom. Any reading above that band would suggest an insufficient shakeout. Therefore, in that situation, investors should exercise patience.

Following a visit to the 90 to 100 degree band, investors should then watch for a sharp reversal by the stock market indicator. A clue of an imminent reversal could come via a bullish indicator divergence around the 100 level. Once the ContraGauge jumps and trend highers, investors may want to consider dipping their toes in the market, commencing a strategy of contrarian investing. Leaders off the bottom are very often the stocks that turned up before the rest of the market, exhibiting outperformance over the preceding weeks. Moving back above 180 degrees signals the passing of the bear market.

Case Study - Recent Bear Market Bottom

Late December 2018 saw a pretty awful stock market sentiment situation. Our stock market indicator detected such, with readings hitting the 100 degree level. However, a sharp snap-back soon followed, with the market, and the ContraGauge, rising just as quickly as they fell. The reversal called for short covering. In the final week of January 2019, contrarian investing was signalled, as the stock market indicator gained a footing back above 180 degrees. In turn, a new bull market was born.

Contrarian indicator of stock market sentiment at bear market bottom in December 2018.

Historic Case Studies

Momentous peaks and troughs in the U.S. stock market have been used to backtest ContraGauge.

Below, historical periods of stock market distress, or excitement, and the corresponding stock market indicator readings.

Contrarian Indicator readings at Market Tops

Case Study - Nasdaq 2000 bubble

The NASDAQ Composite peaked on March 10th, 2000. Our contrarian indicator registered a reading of 272 degrees at the height of the dot-com bubble. A mania situation, characterized by excessive stock market sentiment. Subsequently, the implosion resulted in the NASDAQ collapsing 78% over two years.

NASDAQ-Composite-bubble-high
Case Study - October 2007 Financial Crisis

The S&P 500 topped out on October 11th, 2007. Our contrarian indicator that day came in at 269 degrees, reflecting an excessive overbought condition. The financial crisis followed and the index bottomed in March 2009.

Market timing at the Financial crisis peak of October 2007.
Case Study - January 2018 stock market peak

A drop of 21.4% followed the NYSE Composite's January 2018 peak. The ContraGauge clocked a reading of 263 degrees on January 26th of that year. Although not a mania situation, the index was technically overbought. Stock market sentiment reflected extreme optimism. Additionally, greater readings by the contrarian indicator had printed in the preceding days, creating a short-term bearish indicator divergence. Divergences typically forewarn of trouble.

Stock market indicator reading on the NYSE Composite at the January 2018 peak.

Contrarian Gauge at Market Lows

Case Study - 2016 stock market correction low

The U.S. market corrected peak-to-trough by 20.5% during 2015 and 2016. Poor stock market sentiment was partly attributed to a slowdown in China. The NYSE Composite bottomed on January 20th, 2016. ContraGauge registered a reading of 94 degrees at the correction low.

Contrarian investing example - the NYSE Composite at the January 2016 stock market bottom.
Case Study - March 2009 stock market bottom

The financial crisis of 2007 through 2009 saw the NYSE Composite sink 60%. The index bottomed on March 6th, 2009. A reading of 91 degrees was shown by our contrarian indicator at the bottom. ContraGauge reflected a capitulation condition,  the perfect opportunity for contrarian investing.

Contrarian indicator reading at bottom bottom of March 2009.

Contrarian Investing - 3SR signal explained

A proprietary trading system to complement the ContraGauge.

The 3 Stage Reversal (3SR) system anticipates how the majority will read, and interpret, the technicals of the market. In turn, their likely action may be anticipated, thereby enabling effective market timing above the crowd.

Therefore, 3SR identifies the opportune period to initiate positions against the technical analysis consensus. The system identifies points at which the risk-to-reward ratio is at its best. Additionally, when the 3SR system is applied to the general market, the ContraGauge brings further evidence to the table.

In essence, the 3SR is an expanded bear or bull trap, across a lateral level of significance. The system involves three distinct stages: Shakeout, Shrug and Snare.

Below we explain the 3SR system on contemporary charts, such as a line, bar or candle chart. The 3SR equivalent on Point & Figure charts has additional rules. As a result, the P&F 3SR suits the more conservative contrarian investor.

Digram illustrating a system for contrarian investing.

1. SHAKEOUT

The Shakeout stage (S1) is a price break through significant support or resistance, often a prior high, or low, of importance to the market. Typically the break coincides with a well telegraphed news event, the catalyst. Good news event on an upside break through resistance. Bad news on a break down through support.

The level break sparks euphoria in the case of an upside breakout or despair with regards to a breakdown. Heightened emotion spurs traders into action. Opening longs on the breakout or the covering of short positions. Alternatively, selling longs on the breakdown, or the entry of fresh short positions. Emotions run high on major breakouts or breakdowns. Consequently, volume swells.

2. SHRUG

The Shrug stage (S2) is where the catalyst (news event) loses its influence over the price. During this phase, the event is fully priced in and the market begins to shrug the news event off. The market no longer cares for the catalyst. The stage manifests on the chart as a direction reversal, with the price recovering towards the level breached by the shakeout stage. Traders see this as an opportunity to wrongly add to positions in the direction of the original catalyst. However, position adding only exacerbates the next phase, the snare.

3. SNARE

The final stage, the Snare (S3), provides complete activation of the 3 Stage Reversal set-up. S3 provides confirmation, the cue to enter contrarian positions, playing for the turnaround. Contrarian investing in the case of a bullish 3SR. S3 appears on the chart as a move back above broken support in the case of a bullish 3SR or beneath broken resistance for a bearish 3SR. The snare stage is essentially trapped trading positions being forced out. A short-squeeze for the bullish 3SR. Alternatively, the selling of underwater longs with respect to the bearish 3SR. This final phase can endure for some time and often fosters a new trending phase. Frequently, traders fail to exit on the reversal, hanging onto hope that the catalyst influence will return. Furthermore, traders add to losing positions to temporarily alleviate the pain. However, such activity ultimately feeds the snare further.

The 3SR system for market timing at a stock market peak.
Frequency

The 3SR can appear on any time period, from tick data all the way up to quarterly charts. Short-term signals are referred to as minor. Long-term signals, breaks of levels dating back months to years, are labelled as major signals.

The Point & Figure equivalent of the 3SR mostly detects major signals. Essentially, the same in terms of the involvement of a significant level, along with consideration of market psychology. Also, used in conjunction with our contrarian indicator, at the macro level.

Price Target

The target of a 3SR is the opposing boundary of the dominant range. Therefore, in the case of a bullish 3SR, initial target is typically back to the most recent peak. Alternatively, the target is a notable trough with regards the bearish 3SR.

Stop-Loss

Stop-loss on a 3SR needs flexibility initially. At first, the stop should not be fixed, since such reversals are volatile. Thus, intraday stops should be avoided. Instead, watch for consecutive closes beyond the extremity of the reversal and then exit accordingly. We prefer three consecutive closes beyond the extremity, exiting on the fourth session (when using daily charts). As the new trend develops, the stop-loss may be trailed higher.

Conclusion

An investor's animal spirits are suppressed by a quality stock market indicator, coupled to a rule based system.

ContraGauge outputs a simple value. As a result, human subjectivity is eliminated. Objective contrarian investing achieved effortlessly and effectively.

A trading system, such as our 3 stage reversal, provides a chart road-map. Thereby, guidance is provided, as are the principles of contrarian investing.