Wisdom of crowds and correct contrarianism

Financial uber-blogger Richard Beddard has this fascinating chart up today (see above). He notes that:

The story is familiar to practicing investors. At stockmarket extremes, psychology drives the market and overconfidence or lack of confidence pushes prices to highs and lows. In between the peaks and troughs the performance of companies, and their valuations matter more.

The percentages are just opinion, but the investment styles that do best in different phases of the market are fact, at least judging by the last stockmarket cycle. Morgan Stanley demonstrated that cheap shares do best in the early and middle stages of bull markets. Growth and momentum are most important at bull market peaks and a fourth factor, the strength of company balance sheets, is critical for performance in bear markets.

And the conclusion:

To make a killing, all you’d have to do is consistently identify which phase of the market you are in. If that were possible you could adapt your strategy, and the investment ratios you use. In the early stages of a bull market you’d buy shares with low prices compared to their book values, annual sales, or profits. As the bull market peaked you’d gradually switch to momentum, buying shares that have recently gone up in price, and growth, companies which are expected to grow their profits impressively. In a bear market you’d switch to owning companies with low debt.

You’d be the perfect herd-anticipator and by deftly switching from one style to another you’d avoid being trampled when the herd changed direction.

As Richard points out, seeing this in hindsight and seeing it in foresight are two different things, but the overall point here - that there is a "meta" above the market that is driven by the shift in people's opinion - and that it is predictable, and beatable by being correctly contrarian in my view goes further than just investing. This is probably an illustration of our behavioural psychology (and economics) en masse.

For example, I suspect we can use this sort of thinking and apply it to Hype Cycles, to predicting technology takeup and a whole host of non-financial uses that depend on the dynamic sift in opinions of people.

And its far easier to do in social media as it is all already digital, so the data is there - all it needs is correct processing. Now I am sure Google et al, like the big Merchant banks, has stumbled on this already, but it would help a lot if the small user was aware of the potential.

So now you are aware