In Your Face

They don't know squat. Their recommendations are bogus and history proves it-market analysts have a lousy record. In his book, Contrarian Investment Strategies: The Next Generation, David Dreman drags the Wall Street analysts through the mud as he discloses why being a contrarian makes a lot of sense. John Bogle, chairman of the Vanguard Group, trumpets the study that showed that 90% of fund managers underperformed the market in every 10 year period since records began in the 1960s. As further testament to the "false gurus", all the "smart money" was out of the market in ´87 but the "dumb money" stayed in and reaped the benefits when the market came roaring back.

Contrarians postulate that analyst recommendations help set up the overconfidence and emotion that makes it possible to make investments that take advantage of the positive affects of surprise. The basic premise is that the favored stocks usually underperform and the out-of- favor stocks out- perform the market. As a matter of fact, if a contrarian investor sees that 70% of Wall Street experts are bullish-a contrarian investor knows the market is topping out. Conversely, if the experts are 70% bearish, it's a good time to invest. For those familiar with the technical tool-Relative Strength Index (RSI) - it does basically the same thing in that a buy signal is given when a stock is over-sold and a sell signal is generated when a stock is over- bought.

A contrarian investor looks for stocks that are solid but out-of-favor. Being solid can be defined as having a low price-to-earnings ratio, a favorable price-to-cash flow and a favorable price to book value. As option investors look closely at the underlying stock, contrarian fundamental investment strategies can be a very valid strategy.

Dreman goes on to list a series of 21 rules and 3 strategies for a contrarian investor to apply to their investing system. The three strategies are:

1. Look for stocks with a lower than industry price to earnings ratio.
2. Look for stocks with a lower than industry price to cash flow
3. Look for stocks with a lower than industry price to book value.

He also recommends that an investor in a contrarian stock should exit when any of the above criteria move back into the normal range.

Bottom line, contrarian investing is dedicated to using the consensus opinion of analysts and gurus as a contrarian indicator. Favored stocks and investments are to be avoided. A guru bullish fever is a signal to sell stocks and investments. Excessive Guru bearishness is a time to buy stocks and options. Additionally, according to Dreman, investors should look for "value stocks" which are for some reason off the radar or out of favor. These stocks have the powerful element of surprise which can have an explosive impact on price movement and is a powerful attraction for the mob chasing alpha.

As a stock option trader or stock investor, a contrarian point of view can form part of an effective investing strategy. However, a trader must be aware that a stock option with a thin market is something to be concerned about.