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Computerized Investing > First Quarter 2012

Contrarian Indicators

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by CI Staff

The efficient market hypothesis states that the financial markets are “efficient,” meaning that they should already fully incorporate all available information. However, it is also true that the stock market generally goes through periods of being undersold and overbought. How can we explain this phenomenon? One possibility is investor emotions.

Although investors would like to imagine that their decisions are rational, most have bought at near-highs due to fear of losing out on gains and sold at near-lows due to fear of further losses. This herd behavior is called market sentiment; when market sentiment is low, the majority believes the market will fall, while high market sentiment means that the majority feels the market will rise in value. However, more often than not, the market will move against the sentiment of the majority. Therefore, many professional money managers use market sentiment as a contrarian indicator, buying when sentiment is pessimistic and selling when sentiment is optimistic.

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