In our Schaeffer's Media Outtakes series, Bernie Schaeffer dissects the news, using contrarian analysis to provide a unique take on the market.

"Sentiment works as a contrarian predictor of equity markets because when they get deeply depressed, central bankers and governments step in with the policy equivalent of a giant dose of Prozac to fix things ... Support from the central bank and fiscal authorities during panics often annoy those who believe in 'tough love'. We disagree with this 'tough love' mafia. In a panic, reviving the patient quickly is critical, a moral lecture in the emergency room is totally counter-productive ... Historically, with rate cuts and no recession, equities do especially well the median six month return from equities is 20.1 per cent (excluding 1998, where the rebound was spectacular, the median is still 13.7 per cent). There are two conclusions we can take from this. First, rate cuts are generally good for equities. Second, rate cuts without recessions have been great periods for equity markets. So a key question becomes: is a recession on the way? We think not. Companies are in good health. Cash flow is exceptionally strong, the cost of funds (even given credit conditions) remains manageable, inventories are not bloated and capital expenditure remains low ... Rate cuts and a small chance of a recession are good news for equities."
---(The Financial Times "US rate cuts impact on outlook for equities" 10/3/07)

Schaeffer's addendum: This was an excellent and insightful guest piece, written by Ajay Kapur, a founder of First Horse Capital, the Hong Kong based hedge fund.

I am particularly enamored of Kapur's description of the "tough love mafia" the throng of so-called purists (which, of course, included a horde of short-sellers whose motives were anything but pure) who stomped their feet and threatened to hold their breath till they turned blue if the Fed were to dare "rescue Wall Street" by cutting rates correctly equating their antics to confronting the critically ill patient with "a moral lecture in the emergency room".

I also love Kapur's explanation for why deeply depressed sentiment can be such an effective buy signal for the stock market. I would add to this, though, that it's not just the tendency for governments to come to the rescue that can make extremes in bearish sentiment a good contrarian indicator. By definition, deeply depressed sentiment means that investors are looking at a situation and seeing no way it can improve, which is often not grounded in reality. The classic "The Tragedy of General Motors" Fortune cover story from February 2006 illustrates this point well.

Also, to the extent the depressed sentiment occurs within the context of a pullback in a bull market (as opposed to in a bear market), the potential effectiveness of the contrarian interpretation is greatly enhanced because the "disconnect" between sentiment and reality (as measured by price action) is wider. This was the case with the recent stock market pullback.

If you believe Bill Gross' interest rate scenario of aggressive rate cuts ahead and if you also believe (as I do) that the U.S. economy will be ok, then you have to be bullish on equities. And this does not take into account the additional bullish factors (pointed out regularly by Charles Biderman) in the areas of share buybacks and "float shrink."

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