Using Contrarian Indicators to Determine Market Tops & Bottoms

11/04/03 08:44:05 AM

by Kevin Hopson

Contrarian indicators like short interest, analyst ratings and bullish percent levels can all be used to help gauge market sentiment. In this article, I compare oil service stocks to integrated oil stocks to see which sector has the best chance of moving higher in the near-term.

Security: OSX, XOI
Position: N/A

I am a big fan of contrarian investing, meaning that I like to use market sentiment - in addition to technical analysis - to help find ideal trading opportunities. For example, there are three main indicators that I tend to use: short interest, analyst ratings and bullish percent numbers. When short interest is on the increase, analysts are becoming more negative in their opinions and the market status is bullish, which are good signs that higher prices will prevail. In other words, overly pessimistic market sentiment can act as a good bottom indicator, while the opposite is often true for market tops. Just to elaborate, short interest is the amount of shares that have been borrowed (on margin) and sold back into the market. Since short sellers will have to eventually buy back these shares to close out their position, it is a good indicator of potential buying pressure. Obviously, the higher the short interest, the more shares that will have to bought back in the future. If a stock moves against the short seller (appreciates), it can create what is called a "short squeeze" where short sellers are forced to buy back the stock in an attempt to limit their losses. This can add fuel to the fire during a rally.

Though many market participants have become less trustworthy of the investment community since the Enron debacle, analyst ratings are another excellent contrarian indicator. One reason is that some firms have a stake in the stocks they cover. When this is the case, it is in the firm's best interest to have a large position in the stock prior to upgrading it. This means that much of the buying has either been done already or institutions are going to use the upgrade as a means to sell part or all of their position in the stock. Either way, when the small investor is the last to get in, it is usually a sign of a forthcoming top. Obviously, one upgrade would not be indicative of a top but if you were to look at all of the analyst ratings for a particular stock, you could better gauge the market sentiment.

Graphic provided by: Yahoo Finance.

The third indicator I use is the bullish percent. This is the percentage of stocks that are currently on buy signals. A buy signal is given when prices breach a prior high. You can use the bullish percent a number of different ways but I like to use these figures as a measure of sector strength. For example, much like the stochastics indicator, a sector is considered overbought when the bullish percent is above 70 and oversold when the bullish percent is below 30. Obviously, when the bullish percent is oversold and moves above 30 (breaching a prior high in the process), it is the most opportune time to enter. This is where the contrarian value comes into play. However, the bullish percent can also act as a confirming indicator. More specifically, it is possible for the bullish percent to stay above 70 (or below 30) for months at a time. If you were to liquidate all of your positions when the bullish percent first moved above 70, you could lose out on a lot of additional upside. As a result, you want to watch what happens once this occurs. For example, if the bullish percent moves back below 70 and breaches a prior low in the process, the sector would be in confirmed bear market. On the other hand, if the bullish percent pulls back but stays above 70, it could just be a short-term correction before prices move higher again. Obviously, there is no way of telling if a drop below 70 will occur or not, which is why I like to use the other indicators to assist me in my decision making process.

As an example of how to use these indicators, let us compare the Oil Services Index (OSX) to the AMEX Oil Index (XOI). The OSX is made up of oil service companies, while the XOI is made up of integrated oil companies. If you wanted to invest in the oil industry but were unsure of which sector to buy into (oil services or integrated oils), you could look at short interest, analyst ratings and the bullish percent for these two groups. As you can see in the one-year chart, the XOI (+14%) has outperformed the OSX (+2%) over the last twelve months. Does this mean that oil service stocks are currently out of favor and should eventually catch up to integrated oil stocks on a performance basis? Not exactly.

Though it is true that oil service stocks are out of favor performance wise, market sentiment towards the group continues to be positive. For example, despite lower stock prices over the past month, short interest for the group has declined by roughly 10 percent. Additionally, the bullish percent has reversed down and is now below 70, meaning that the sector is in "Bear Alert" status. Unfortunately, 51 percent of the analysts covering these companies currently have buy ratings on the stocks. This is nearly unchanged from the 53 percent reading we saw last month. When prices are moving lower, market sentiment is improving (as indicated by the short interest) and the sector is in a bearish mode, it usually indicates further downside potential for the group. Integrated oil stocks, on the other hand, are looking much more bullish. For example, short interest has grown nearly 14 percent over the last month. Additionally, though the percentage of analysts with buy ratings on these stocks only fell 1 percent from last month, the current reading (41 percent) is still pessimistic. This is much lower than the oil service group, meaning that integrated oil stocks are more out of favor right now. Furthermore, the bullish percent has started to pull back but is still sitting around the 80 percent level, well above the 70 percent warning level. As a result, the group looks to be in a "Bull Correction" mode right now. With sentiment becoming more pessimistic, it appears that integrated oil stocks have further upside potential. This means that the XOI could continue to outperform the OSX in the near-term.

Kevin Hopson

Kevin has been a technical analyst for roughly 10 years now. Previously, Kevin owned his own business and acted as a registered investment advisor, specializing in energy. He was also a freelance oil analyst for Orient Trading Co., a commodity futures trading firm in Japan. Kevin is currently a freelance writer.