Contrarian investors depend on the ability to distinguish between fair value and market mispricing. When markets become gripped by fear or exuberance, asset prices often move away from their intrinsic worth. Identifying these dislocations is central to the contrarian approach. While no single tool offers certainty, a combination of valuation metrics, sentiment indicators and market internals can help form a reliable picture of whether a market or asset is overvalued or undervalued.
VALUATION METRICS: GAUGING FUNDAMENTAL MISPRICING
Valuation analysis forms the foundation of most contrarian strategies. When markets are driven by emotion rather than earnings or economic performance, traditional valuation ratios often signal excess. For equities, key measures include the price-to-earnings (P/E) ratio, price-to-book (P/B) ratio and price-to-sales (P/S) ratio. In periods of overvaluation, these ratios typically expand well beyond historical averages, especially in sectors experiencing strong momentum or speculative interest. Conversely, undervalued markets tend to show depressed valuations, often following periods of underperformance or negative news.
Contrarians examine these metrics in historical context rather than in isolation. For example, a P/E ratio of 15 may appear fair on its face, but if a sector has historically traded closer to 10 during similar economic conditions, it could indicate overvaluation. Similarly, an asset trading below book value may suggest undervaluation, particularly if the underlying business remains profitable and solvent.
At the index level, broader valuation measures such as the cyclically adjusted price-to-earnings (CAPE) ratio or market capitalisation-to-GDP ratio provide signals about the state of the market as a whole. These tools help contrarians identify when entire regions or asset classes are priced for perfection or trading at distressed levels, offering a macro-level view of sentiment extremes.
SENTIMENT INDICATORS: MEASURING MARKET PSYCHOLOGY
While valuation speaks to fundamentals, sentiment indicators offer insight into investor behaviour. Contrarians use these tools to assess the emotional state of the market and determine whether prevailing attitudes are likely to lead to mispricing. One of the most commonly used sentiment indicators is the American Association of Individual Investors (AAII) sentiment survey, which measures the proportion of respondents who are bullish, bearish or neutral on the market. Extremely high bullish readings often precede corrections, while deeply bearish readings can mark major market lows.
Another widely tracked measure is the put/call ratio, which compares the volume of bearish put options to bullish call options. A high put/call ratio signals widespread pessimism, while a low ratio may suggest complacency. Similarly, investor flows into equity or bond funds can highlight where capital is concentrating. Large inflows into a specific sector or asset class often signal a degree of consensus that contrarians interpret as a warning.
Media tone is also a useful indicator. When headlines are universally positive and valuations are ignored in favour of growth narratives, contrarians take note. On the other hand, when financial news is dominated by warnings of collapse and pessimistic forecasts, they begin to search for overlooked value. These extremes in sentiment, while difficult to time precisely, often provide the conditions for future reversion.
MARKET INTERNALS: LOOKING BELOW THE SURFACE
Contrarians also examine market internals – data that reflects the strength or weakness of price movements beneath the headline index levels. Breadth indicators, such as the advance-decline line, show how many stocks are participating in a rally or decline. Narrow rallies, in which a small number of high-profile stocks drive index performance, can signal fragility and an overreliance on sentiment rather than fundamentals.
Relative strength indices (RSI) help measure whether a market is overbought or oversold. While not conclusive on their own, extreme RSI readings can support a contrarian thesis, especially when combined with weak internals and stretched valuations. For example, a sector experiencing a sharp rally despite deteriorating earnings or low participation from smaller constituents may be a candidate for reversal.
Short interest data provides additional insight into positioning. High short interest can reflect bearish consensus, but if fundamentals appear sound, it may also present an opportunity for contrarians anticipating a rebound. Conversely, extremely low short interest might suggest that investors are overly confident, potentially leaving little room for positive surprises.
BUILDING A COMPOSITE VIEW OF MARKET EXTREMES
Contrarian investors rarely act on a single signal. Instead, they build a composite view by aligning valuation, sentiment and market internal data. A market that is overvalued by historical standards, characterised by widespread optimism and deteriorating internals, is more likely to offer a contrarian short opportunity. In contrast, a market trading at depressed valuations, accompanied by high fear levels and strong underlying fundamentals, may present a compelling case for investment.
This multidimensional analysis allows contrarians to avoid common pitfalls, such as mistaking a declining market for a bargain without assessing sentiment or chasing a rally without recognising the risks embedded in stretched valuations. It also reinforces the importance of patience and discipline, as these signals often emerge well before the market corrects or recovers.
By combining analysis with an understanding of investor behaviour, contrarians position themselves to act decisively when the market reaches an emotional extreme. Their goal is not to predict exact turning points, but to identify areas where mispricing is most likely to revert, driven by the eventual return of rational judgement to the marketplace.
To learn more about contrarian investing, visit Orbis Investments' Contrarian Investing Playbook.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.