DANGER: THE RETURN OF ISB SYNDROME!
by Clif Droke
September 28, 2007

A highly infectious virus is spreading like wildfire across the Internet.  It has done untold damage to the bank accounts and hard drives of millions.  It leaves in its wake a path of destruction and a feeling of utter helplessness.  You may, in fact, be one of its victims!

This destructive malaise is known as ISB Syndrome. 

* The virus has already resulted in losses totaling in the billions of dollars for countless traders and investors. 

* It comes in several forms and is spread mainly through Internet downloads of financial news and commentary web sites. 

* It has been known to corrupt the programming of the host to the extent that it causes a complete systems shutdown, rendering normal processing of information virtually impossible.

Now before you get all panicked and start performing a systems check on your computer – relax!  I’m not referring to a computer virus but to a psychological “virus” of sorts.  “ISB” stands for Irrational Super Bear Syndrome.  The “critical systems shutdown” refers to the damage done to the faculty of common sense reasoning by this psychological plague. 

Make no mistake about it, ISB Syndrome can be just as devastating as an actual computer virus since it can contaminate the “hard drive” of your mind and cause you to make fatal investment mistakes.  It can cause you to make errors that result in a significant loss of your hard-earned dollars and investment capital.

If you’re like most people, you’ve been heavily exposed to the super bearish investment outlook of the mainstream press for the past several months.  It’s nearly impossible to listen to the talking heads on TV or read the pundits in the financial press without being infected.  After all, there’s a lot of pessimism out there!  That’s why so many investors today are bearish on the stock market outlook despite the main trend for stocks being firmly up.

Now you’ve given the bears a fair hearing…yet those bearish investment advisers haven’t done anything to improve your bottom line as an investor, have they?  So ask yourself, can you afford any longer to give ear to the bearish rants of the financial press?  Wouldn’t it be better instead to invest *with* the trend instead of selling short against it? 

If you answered “yes” to this last question then there is still hope!  In a minute I’ll show you how contrarianism applies to the current PM mining stock outlook.  But first…

There’s a fascinating story worth sharing here, a story of how a fortune was lost -- and recovered -- with the aid of news headlines.

Our story concerns a young trader who made a fortune selling short the stock market in the summer of 1998…only to lose it all, and then some, in the recovery rally that began in October of that same year. 

His name was Tom and our hero lost thousands shorting the stock market at the bottom of the big market decline of ’98.  At the time nearly everyone was convinced the stock market was headed lower and that an economic recession – or worse – was right around the corner.  Everyone was afraid and soon the super bearish forecasts began appearing on TV.  Several big name financial pundits were telling everyone to mortgage the farm and short the stock market like there was no tomorrow!

Tom took this message to heart and began buying puts on the OEX and selling short some major blue chip stocks in the Dow 30 index.  Imagine his shock and horror when he went to his online trading account one morning only to discover he was several thousands of dollars in the red!  He was quickly forced to cover his positions.  He had learned a hard lesson about taking the advice of the super bears.

Is there a happy ending to this story?  Yes there is! 

Tom was determined to find out what went wrong in the fall of 1998. 

Why had he listened to those who were gloomy on the stock market outlook when the direction of the market’s main trend was clearly up?  After some reflecting he realized his pitfall had been listening to the bearish commentators in the financial press.  So he returned to those same newspapers (the ones that had led him to go bearish earlier that summer) and magazines and newsletters to see what had happened.  He was looking for any clue he could find to tell him why he had been so misled by those bearish headlines.

Suddenly it came to him like a thunderbolt from heaven!  He wasn’t wrong to read those bearish financial stories.  In fact, he realized was on the right track all along -- he was just going in the wrong direction!  His discovery was astounding yet so simple:  It wasn’t the bearish headlines that caused him to lose money; it was his interpretation of those headlines.  Put another way, Tom realized he should have been *doing the opposite* of what the headlines and bearish pundits were telling him to do.  Contrarianism was the key!

Maxwell Maltz once said, “Close scrutiny will show that most ‘crisis situations’ are opportunities to either advance, or stay where you are.”  That statement rang true for the hero of our saga.  Tom made the discovery that by going opposite the crisis-laden financial news headlines he was sure to come out on top in most of his trades.  He had stumbled upon the key of the Contrarian Principle quite by accident.

Contrarian investing is easy, yet most investors refuse to take advantage of it.  Why?  Because we’re psychologically primed to listen to the mainstream media (MSM) and take the newspaper headlines at face value instead of using our better judgment and trading against the headlines.  

After all, what makes the financial news is commonly available to everyone has already been discounted by the stock market.  This means it has little value by the time it reaches the small investor.

There is definitely some value to be derived from news headlines.  Quite a bit of value, in fact.  The real value in news headlines is in watching for a “consensus of direction.”  In other words, look to see whether the majority of headlines are painting a bullish or a bearish outlook for the stock market.  

Once you’ve determined which direction the headlines are pointing (and it’s really quite easy to do) then you can take the contrarian approach and go in the opposite direction of those headlines.  

For instance, if the headlines are telling you there’s a lot of crisis out there with housing prices in the doldrums, banks in trouble and credit in short supply, you can take a contrarian stance and assume the worst of these problems have already been worked out.  Otherwise they wouldn’t be so prominent in the everyday news headlines.  

A rule of thumb to remember is this: the financial insiders never want us (the outsiders) to know of these problems until after the problems have already run their course and have been thoroughly digested by the stock market.

Here are some of the headlines that confronted trader Tom back in 1998:

•    Market Watch: Bracing For Mortgage Losses 

•       Despite Late Rally, Dow Ends A Bad Week Lower 

•       Shift To Capital Markets From Banks Brings Tumult 

•       Crisis Goes Beyond The Balance Sheet 

•       Banks Tighten Some Loan Terms 

•       Commercial-Mortgage Issuers Are Locked In A Deep Freeze 

•       Recession Fears Dominate 

•       Market Turmoil Hits Luxury Home Sales 

•       Heavy Spenders Take A Break 

•       Decade of Moral Hazard 

•       Emerging-Market Investors Get Full-Fledged Drubbing 

Do any of these headlines sound familiar?  Yes, they’re nearly identical to the ones we’re seeing today Tom recovered his fortune back in the fall of 1998 and you can follow this same path.  Just remember to build a “consensus of direction” with the news headlines and go the opposite direction.  By taking this contrarian approach to the news, you can come out a winner!

Now what about the PM mining stocks I promised to talk about?  The trend for the gold and silver stocks has been bullish of late and this was in no small part a response to the bearish sentiment the public sector was showing on the mining stocks in August. 

The key here wasn’t just with the public’s negative sentiment but with the “smart money” traders.  They were heavily buying calls on the gold stocks in August and early September as shown in a number of call/put ratios as well as in the CBOE Gold Index (GOX) call/put open interest ratio.  Take a look at this bullish chart below and see for yourself just how heavily the smart money was buying the gold/silver sector

Even now, after the XAU and HUI gold/silver stock indices have gone on to new highs the level of call buying exceeds put buying with the implication that the top isn’t in yet.

Silver stocks were late in joining the party this month but have been making up for lost time in the past several days.  As I pointed out in last week’s commentary, the upward turn in the 30-day internal momentum for the silver stock group was expected to provide a continued upward bias for the leading silver stocks.  In other words, higher highs were expected for the major actively traded silver and for the most part we’ve seen this. 

The upside potential hasn’t been totally exhausted for the leading silver stocks and we could still see more rallies into October before the next rally top.