Contrarian Investing: Looking for Signs of Herding

The difference between the “madness of crowds” and the “wisdom of crowds” can be summed up one one word: herding.  When investors think and act as individuals, the crowd is effective at establishing “correct” prices, and the market is efficient.  This is the beauty of a market economy.  But when investors think and act as a herd, independent judgment is lost, prices lose their rationality, and assets get mispriced.

In extreme cases, we get bubbles and panics.  But even under more mundane conditions we get relative mispricings as investors chase “hot” sectors and ignore others.  This is why, even after all these decades, the basic principles of value investing still work.  Unless the human race somehow evolves out of its tendency to herd, opportunities will exists for contrarians willing to go against the grain.

One of my favorite methods in tactical asset allocation is to look  for signs of investor herding and take a contrary position.  Herding can take many forms and can be done by both retail investors and professionals–and often both at the same time!  Unfortunately, herding can sometimes be hard to quantify.  You have to know where to look.

Barron's periodically publishes surveys in which Wall Street strategists give their opinions on their favorite and least favorite sectors.  Strategists, of course, tend to talk their book.  If they like a given sector, chances are good that their firm has already acted on their recommendation long before the public sees it.

In looking for herding behavior, I like to see Barron's strategists either fawning over–or shunning–a given sector.  Ideally, 70-80% of the strategists will be making the same recommendation.

So, what did Barron's most recent survey reveal?  Unfortunately, not much at all.

Strategist opinion is remarkably diverse.  No sector was loved or hated by more than half of the participants.  For most sectors, bullish and bearish opinion were roughly even.  I do see a couple cases of mild herding:

• 50% of the strategists were bullish on technology, and 0% were bearish
• 40% of the strategists were bullish on industrials, and 0% were bearish
• 40% of the strategists were bearish on consumer discretionaries, and 0% were bullish

Given the attractive valuations found in the tech sector, this is one area in which I would have to resist the urge to bet against the crowd.   I would, however, be comfortable underweighting industrials IYJ and overweighting consumer discretionaries VCR.

I should reiterate that this contrarian indicator is giving only a weak signal at this time.  Within the stock market, herding behavior is largely under control–for the moment.

There are perhaps some signs of herding in other markets, however.  Investors and central banks alike appear to be adding to their gold holdings even as the price hits new all-time highs and the metals traditional uses in jewelry continue to decline.  While I don't recommend a gold short at this time, investors may want to at least rebalance and reduce their holdings of the yellow metal.

Charles Lewis Sizemore, CFA

This blog is a free service of Sizemore Financial Publishing LLC, publisher of the Sizemore Investment Letter.

If you're not reading the Sizemore Investment Letter, then you are missing out on rock-solid investment recommendations designed to profit from the major macro trends shaping the world today.

SUBSCRIBE TODAY to a 3-month FREE TRIAL and get access to information that is simply not available anywhere else.