Posted by Joseph Y. Calhoun, III

The name of this blog is Contrarian Musings for a reason. Investing is nothing more complicated than buying low and selling high. The only way to accomplish that is to be a contrarian. Investments for which there is little demand will be available at favorable prices. Investments for which there is great demand rarely offer a bargain. A contrarian buys the former and shuns the latter. Of course that is easy to say and hard to do. Going against the crowd is an uncomfortable experience and isn’t easy to do. In fact, most people can’t do it which is why the average mutual fund investor manages to vastly underperform not only the averages but even the average mutual fund.

Right now, the vast majority of my research efforts are concentrated on the stock markets of the world. Specifically, stock markets that others are shunning are where I expect to find the most compelling bargains. Those markets would include not only the US but also Europe and Japan. Generally, emerging markets are not unloved or unappreciated by investors and while I maintain investments in them because I think the trend has more to go, the companies there aren’t all that interesting from a micro view. From a macro standpoint, their economies are performing well but that is already baked in the cake so to speak. From this point it will take unexpectedly positive news to move those markets higher and while that is possible - heck maybe even probable - it isn’t the same as finding great investments that are cheap on an absolute basis.

Just being a contrarian isn’t enough to be a good investor though. Cheap investments can get cheaper and dear ones more dear. What a good investor is looking for is a market, sector or investment that is absolutely cheap and on the verge of a positive catalyst. One way to find such investments is to look for positive price action in the wake of demonstrably bad news. A great example is the action in home builder stocks this week. The news on the housing market this week was truly awful. Both existing and new home sales fell precipitously, down 27.2% and 12.4% respectively. Inventories of both also rose. Obviously that isn’t good news for home builders and yet the stocks have not reacted negatively. In fact, the stocks rose after the release of both reports and are considerably higher than their lows of last year:

The same could be said of the stock market as a whole. The economic news has been absolutely brutal over the last few weeks and yet the market is still well above the recent lows set in early July and actually closed higher today in the wake of the awful news on housing and durable goods orders.

(By the way, I’m no technician but that pattern in the S&P 500 chart looks suspiciously like an inverted head and shoulders patter.)

We also have evidence that the sentiment is reaching some kind of extreme:

NEW YORK (MarketWatch) — Investors are scared–really, really scared.

That’s what our latest MoneyShow.com Investors’ Sentiment indicator tells us, in big, bold, red letters:

HELP!

Our most recent survey of the active, mainly self-directed investors who use MoneyShow.com showed the highest bearish ratings we’ve ever seen–far greater than back in February 2009, just before the market bottomed. Read MoneyShow’s “Investors Aren’t Believers.”

And now, with stocks still 64% off their lows, our usually composed and confident audience, who have kept their eyes on the long-term prize through the worst the markets threw at them, appears finally to have succumbed — or is it capitulated? — to the baser instincts of the reptilian brain.

I would call it “fight or flight,” but after a scary European debt crisis, the flash crash, and a steady drip, drip, drip of dreary economic news, there’s not much fight left in them.

Only 7% of the 657 people who responded to our survey (conducted between Aug. 13 and Aug. 17) expect the Standard & Poor’s 500 index /quotes/comstock/21z!i1:in\x (SPX 1,055, +3.46, +0.33%) to rise by more than 10% by the end of 2010, while another 26% thinks it will rise, but by less than 10%.

So, only 33% of those surveyed could be called “bulls”–a huge drop from the 47% who held those views in May or the 57% who were optimistic in May 2009. Read MoneyShow’s “Steady as She Goes.”

Meanwhile, though the ranks of the very bearish (those who look for stocks to fall by more than 10% by Dec. 31) have remained even at 18%, the percentage of those polled who believe the market will fall but by less than 10% has leaped to 24%.

So, not only is that 42% bearishness the highest since we started polling investors three years ago, it also marks the first time the bears have outgunned the bulls — and by a comfortable 42% to 33% — in the history of our survey.

This survey also records the highest levels of neutrality — 25% — we’ve ever seen. So, one out of every four investors polled thinks the market is going nowhere. (The survey has a 95% confidence level, with a margin of error of four percentage points either way.)

As a contrarian it is often the case that you must make a decision to buy even when the reason for doing so is not obvious. I don’t know what will turn around the housing market but I do know that home sales aren’t going to zero and so the recent drop means we have to be closer to the bottom than we were before. Is this the absolute bottom in home builder stocks? I have no idea but I do know that the companies that have survived this bust will be stronger - a lot stronger - for having done so. Any builder that is not in bankruptcy at this point is doing something right. I will certainly be able to narrow it down with more research and I think the odds of finding something that is a real bargain are very high.

The market as a whole also seems to be trying to find a bottom. We know that individual investors have basically bailed out of the market as US equity mutual fund outflows have been steady for two years. We also know that those same investors have been buying bond funds with an even greater gusto than they are selling equity funds. To me it seems obvious - very obvious - that investors should be looking for stocks, sectors or other risk markets to buy and should be much more interested in selling bonds than buying them. Does that mean this is the exact bottom? Probably not but do you think Warren Buffet worried about that when he was accumulating big positions in Coca Cola and other big blue chips in the 1970s?

Being a contrarian, which means nothing more than being an investor, is not easy. It takes guts to buy when everyone else is selling and to sell when everyone else is buying. But it is absolutely necessary for long term investing success.