Watch Out for the Herd

Cisco Systems (CSCO) offers us an excellent and timely example. Last August, Cisco reported glowing financial results, with fiscal fourth-quarter revenue up 61% and net income exploding 69%. Chris Stix, an analyst with Morgan Stanley, enthusiastically reaffirmed the stock as a Strong Buy. But for those people following the fundamentals or analysts' research, it proved an inopportune moment to get in. Cisco is down about 70% from that date (although surprisingly, Stix's Street cred remains as high as ever).

To understand why generally available information is all but worthless, consider the way in which popular investing strategies lose their luster. For example, buying companies that were being added to the S&P 500 or whose stocks were being split both used to be excellent tactics — until word got out and everybody started playing these angles. The effectiveness of both techniques has all but evaporated in recent years. It's simple: The more people squeezing an orange, the less juice for each to drink.

But there are insights we can use to make money. Just as Peter Lynch counted cars in the Home Depot (HD) parking lot before buying the stock, each of us can also use intelligently researched anecdotal information to make investment decisions. The trick is to look for relationships that others don't see, and to have the courage to trade on your own convictions rather than blindly following those of an Armani-clad analyst.

There are two little-noticed indicators that I like to watch. And folks, even though the major averages have rallied significantly in recent weeks, these two contrarian signals are still screaming "sell."

Contrarian thinking dictates that when public interest in the market is high, so are the prices. Although speculative fervor has cooled in recent months, both the amateurs and the pros have far from curtailed their intense fascination in the stock market, at least as evidenced by the membership ranks of their respective organizations. My hypothesis is that while it's quite possible we've put in a bottom among the widely owned favorites that make up the major indexes, the bottom won't come until we see all traders — amateurs and pros alike, avoid stocks like the plague.

A case in point: The now-infamous 1979 cover of BusinessWeek that proclaimed "The Death of Equities." Coming on the cusp of the spectacular bull market of the 1980s, it proved to be one of the worst predictions in stock-market history. But it does give us a sense of how despondent the equity investor had become after 14 years of a dormant Dow. Survey investor sentiment these days, by contrast, and you'll find that when it comes to the public's long-term belief in stocks, we might be on life support — but we're far from dead just yet.

So what am I watching that tells me these things? When it comes to tracking the pros, I monitor the seat prices at the New York Stock Exchange. Membership on the New York Stock Exchange is traded just like a stock. Its value fluctuates based on supply and demand, and over time, the value has exhibited a strong correlation to the market itself. Currently, the record high for a seat is $2,650,000, set in August of 1999, and while the price has come down in recent months, it hasn't yet corrected as it has after previous peaks. A crash in seat prices would be one indication a more substantial bottom is in place. Historically, seat prices peaked in 1929, 1969, 1987 — all multiyear tops for equities. This is "X-Files" stuff, no?

Amateurs don't join the NYSE, but the NAIC, or National Association of Investors Corp. Founded in 1951, the NAIC serves as an excellent educational resource for investment clubs, social groups of like-minded individuals who participate in trading a common portfolio. Historically speaking, the "little guy" has excellent motives but horrible timing. The membership rolls at the NAIC have also tracked equities: They rise when stocks are up. Interest in investment clubs has stalled in recent months, but not evaporated altogether. That's another bad sign. The real bottom will come when nothing sounds as revolting as spending an evening talking about stocks.

Is my analysis of seat prices and investment-club membership on target? Maybe I'm right and maybe I'm wrong; only time will tell. I give myself permission to be wrong — and I use good trading techniques to ensure that when I am, the inevitable bruises to my portfolio aren't that painful.

The point is that the best choices are those we make of our own intelligent accord. I'm not a strict technician nor a fundamentalist, but a self-interested rational being intent on making a buck. To that end, I find that the strongest trading ideas don't come from a research report, but from my own experiences and observations. In the final analysis, thinking independently isn't just about disagreeing with the herd, but avoiding it altogether.

Jonathan Hoenig is portfolio manager at Capitalistpig Asset Management (www.capitalistpig.com), a Chicago-based hedge fund. At the time of writing, his fund was short shares of Home Depot.