Being a contrarian investor is a lonely path…

Most folks want other people to like and agree with their investment ideas.

When they do, it gives you a sense of comfort that your idea will work well. But that’s not necessarily true…

Our colleague Dr. Steve Sjuggerud’s investing mantra is almost entirely the opposite, for example. Steve looks for things that are cheap, hated, and in an uptrend. And his phenomenal long-term track record speaks for itself.

Another example of this idea comes from natural-resource-investing legend Rick Rule, who often says, “you’re either a contrarian or a victim”…

Steve and Rick have decades of experience in the markets. They’ve been through highs and lows. And even though their work has been in different fields, it’s clear they have come to some of the same conclusions.

Behind their quotes is the understanding that when too many people want to own an asset, it’s often near its top… And when nobody wants to own an asset, it’s often near its bottom.

Today, we’ll look at one consensus bet that says a rally could be on the horizon…

To help us gauge sentiment, we often refer to the Commitments of Traders (“COT”) reports…

COT reports exist for most assets that trade on the futures market, including bonds, stock indexes, currencies, and a wide range of commodities. The reports classify different types of traders and track their futures positions.

Industry professionals (or “commercial” traders) use futures as a way to protect their businesses from price fluctuations. And the folks who often take the other side of their bets – hedge funds and other traders – are speculating.

Speculator sentiment is a “contrarian indicator.” Speculators are often extremely bullish (expecting an asset to go higher) at market tops and extremely bearish (expecting it to go lower) at market bottoms.

When speculators are wildly bullish, it’s a warning sign… And when they’re overwhelmingly bearish, it’s a sign that the asset may be ready to rally.

Today, we’ll consider speculator positioning in an area of the market that could reverse course soon. So you’ll want to make sure you’re positioned properly…

The Russell 2000 Index is the U.S. benchmark for small-cap stocks. It includes about 2,000 companies with market values between $115 million and $17 billion. The health of the Russell speaks to the strength of the U.S. economy… and its smaller businesses.

In the chart below, you can see that the Russell (the black line) plunged from February to March last year. It was down 43% at its lows – its sharpest drop in years. Recently, though, the Russell has soared. As of yesterday’s close, it traded 115% above its March 2020 low.

In the most recent COT report on August 13, speculators’ positions (the blue line) in the Russell totaled about 57,000 contracts “short” (betting on lower prices). In the past, when speculators held about 80,000 contracts short, it marked extremely bearish speculator sentiment… And it has often been a turning point for the Russell…

[On Thursday], the Russell 2000 closed 9.6% below its all-time high. The index has not done much over the past few months. It has mostly traded sideways just below its old highs. Yet speculators are adding to their bearish bets…

If the Russell 2000 climbs higher, it could take off as speculators rush to exit their positions. It could set the stage for a big rally in small-cap stocks.

We should note that the COT history for this index is mixed… Extremely bearish positions have not always marked a low in the index. And vice versa for extremely bullish positions.

But either way, you’ll often find extreme sentiment at key turning points in all markets. And right now, speculators are bearish on small caps.

If you want to bet on the Russell rising, you can buy shares of either the iShares Russell 2000 Fund (IWM) – which is not leveraged – or the ProShares Ultra Russell 2000 Fund (UWM) – which is two-times leveraged.

Keep in mind, sentiment is only one piece of a complex puzzle. It’s not a “magic bullet.” And COT extremes are short- to medium-term indicators. Signals usually wear off after a few months. So you don’t want to place long-term trades based on these signals unless they line up well with your other analysis of the asset.

For short-term trades, though, the COT reports are a great way to find contrarian setups. And that’s exactly what we have with small caps today.

Good trading,

Ben Morris and Drew McConnell

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Source: Daily Wealth