An Unlikely Contrarian Play: Buy the Rally

(MoneyWatch)  The point of Against the Grain is to highlight the virtues of contrarian investing. The guiding principle is that the best way to beat the markets is by hitting 'em where they ain't and zigging when the majority is zagging.

After the best run for stocks since the Great Depression, by some measures, the apparent contrarian play is to sell into the rally. That may not be the case, however, because so many on Wall Street don't believe what they're seeing.

The psychology of a long bear market is hard to break. So instead of hopping quickly on the bandwagon, many investors are treating the market as if it were a ship speeding toward an iceberg.

Gauging Investor Sentiment

One sign of skepticism is the widely followed Investors Intelligence survey of investment advisor sentiment. The April 7 issue found a continued plurality of bears over bulls, 37.1 percent to 36.0 percent, even after the Standard & Poor's 500-stock index gained more than 20 percent in the preceding month.

That ratio may not seem all that negative, and it's the best reading in a couple of months. But stocks go up far more often than they go down, so bears in the survey seldom outnumber bulls. Until the downturn gathered pace about a year ago, in fact, it had not happened since 2002.

Another well regarded sentiment indicator, the CBOE Volatility Index, shows similar results. The VIX uses the pricing of stock index options to calculate the level of market volatility anticipated over the next month.

High levels are a sign of fear in the market, and while the VIX has come down from the record high above 80 reached during the panic last fall, it is lingering near 40, higher than any reading between early 2003 and last September.

A combination of sentiment indicators compiled by Mary Ann Bartels, a technical research analyst at Merrill Lynch, continue to tell her that investors are reluctant to buy the rally and that stocks are therefore still worth buying.

Another positive factor that she mentioned in a note to clients is a recent "breadth thrust with volume confirming." That's technical analyst jargon for one or a few days of heavy trading with an overwhelming proportion of stocks rising.

Time to Buy -- But Cautiously
Bartels deserves to be listened to because she has made some uncanny calls lately. In a column of mine that ran Feb. 13 in The New York Times, when the S&P 500 was around 840, she predicted that the index would bottom at 665. It hit 666 a month later before reversing course. Not bad.

The sentiment readings are a good contrarian indicator, but Bartels acknowledges investors' hesitancy by concentrating her recommendations in more conservative segments of the market. She prefers large companies over small, domestic over foreign, and multinationals over more insular businesses. Companies with high dividend yields are also on her wish list.

After such a big run, many investors probably anticipate a pullback. Nervous shareholders may be thinking about exiting before it happens, while some optimists are probably waiting for it so that they can get in. But the market has a way of confounding expectations and desires, and Bartels suspects it will do so again.

"Despite the impressive rally since the lows on March 6, the market has not given investors [or] traders much of a chance to enter the market," she wrote. "The consensus view is for the S&P 500 to correct part of this rally and test possibly 750-740." Instead, she advises investors to look for "a more modest correction or sideways trading that eventually launches the market to new recovery highs."