Contrarian Investing Framework

We’re going to come up with a better definition of a contrarian trade that gives us a framework for analysis.  In order to do that, it is helpful to look at the behavior of those accepted as charter members of the Contrarian Club.

I nominate Doug Kass as a great example.  I enjoy reading Kass’s column "The Edge," on Street Insight.  Somehow he is able to run his hedge fund, finding the right trades to maintain his success, and still post a real-time log of what he is thinking.  He is also a frequent guest on various CNBC shows.  He takes pride in going against the crowd and finding the contrarian trade.  Right now, he calls himself the "Anti-Cramer."  Jim Cramer, long-time successful hedge fund manager, founder of, and now a TV Star on CNBC, is currently very bullish on the market.  Kass is very bearish.

The stage is set.  I would like to use this to show the strengths and weaknesses of the Kass approach.  A couple of days ago, Kass cited the Business Week Story on forecasts for 2006.  His particular interest was in the economic forecasts, which he said showed evidence of positive bias.  He also cited the strategist forecasts in the same way.

I submit that these two groups are very different.  You can be a successful contrarian with one, but not with the other.  To help show this, let’s open our minds by looking away from the investment world for a moment.

Suppose that you are at Arlington Park, looking at The Racing Form for a big race.  Let us also suppose that there is a group of experts with excellent handicapping information about the race.  They have charted past races, analyzed the "trips charts," and developed their own speed ratings. They throw out certain horses knowing that they will not "be in the picture" at the finish.  The experts are not interested in the heavily-bet crowd favorites, since they have no edge.  They are looking for overlays, situations where the real chances are better than the quoted odds. They are the PhD’s of handicapping and they do their jobs well.

Information about expert thinking has two important impacts.  First, their betting moves the odds.  Second, the information they produce may start to find its way into the crowd.  The odds adjust a bit.  A possible surprise winner might become 5-1 instead of 8-1.  The favorite might drop a little.  In short, expert information changes the price that are available to the bettors.

But notice something important:  The opinions of the experts does not affect the outcome of the race!!  The horses do not know the odds and do not care.  The jockeys are not affected (unless there is a rare fix).

Now let’s go back to Doug Kass.  When he takes a "contrarian" opinion on economics, he is not really finding any edge.  If he had to make his money betting against the consensus economic view that he cites, he would go broke.  Doug cannot change GDP, inflation, or corporate earnings by being contrarian, any more than a handicapping expert can change the outcome of the race.  Whe he takes a contrarian view, he is really saying that he knows more about economics than all of these experts in Business Week.  He has a theory that the consumer is "spent up, not pent up."  Does he not think that the list of economists in the survey think about consumer spending, savings, debt, inflation, business investment, etc.?

This is the trap for the hedge fund manager or "chief global strategist."  You are supposed to think about a lot of things.  If you watch CNBC you will learn that a guy like Doug Kass seems to know economics better than the economists, monetary policy better than the Fed, how to run a company better than the CEO’s of assorted large enterprises in different market sectors.

Doug does not mean it as arrogance, since his writing shows him to be a very nice, caring, thoughtful person.  Nonetheless, it is arrogant when one denigrates the expertise of professionals who spend their entire lives working on something that is a small part of your day.

Doug’s skill comes not from doing economics better than economists, but from understanding how events will be interpreted through the prism of market perception.  At that, he is a true expert.

Here at A Dash, we try to make optimal use of experts in every field.  If other hedge fund managers are not doing so, then we gain an advantage.  When it comes to the economy, we respect the economic consensus, even when we have some opinions of our own.

To summarize:  Being "Contrarian" cannot change GDP or earnings.  Saying that you are "Contrarian" does not really make you smarter or more expert than all of the economists.

You can win by being contrarian on how the market will react, but not on the events themselves.

You, too, can be a Contrarian

How many strategists and managers can be contrarian?  Why does everyone want to be one?

As with many principles, the basic idea is easiest to understand by looking at extremes.  At market bottoms (or bottoms in specific stocks, commodities, etc.) no one wants to buy.  This is a terrific opportunity because the selling is over.  Ownership has moved into strong hands.  There is no one left to sell, so the stock is ready to rise.

At tops it is the opposite.  Think of the famous story about Joe Kennedy and the shoeshine boy who offered him some stock advice.  Kennedy famously sold his holdings, avoiding the ’29 crash, since he realized that there was no one left to buy.  [I had a close eye on a hotel parking attendant in Denver a couple of weeks ago.  He headed for the business center, so I watched to see if he was planning a little online trading.  PHEW!  He was just checking his email.  Don’t laugh.  In 1999 I saw CNBC on in parking garages and assorted retail establishments with everyone checking quotes.]

So every hedge fund manager or strategist wants to be a contrarian, since that shows there is a big opportunity.  You just have to find something where you can contend that everyone else is wrong and you have a lot of edge.

There is a lot of interest in this topic right now, so I plan a series of posts looking at a framework for analysis, some examples of those who are taking contrary positions, a look at some of the indicators and why they are broken right now, and finally, my suggestion for the best contrarian trade.

This Hedge Fund Strategy Ain’t Overcrowded

Everyone wants to be a contrarian.  Here is an interesting suggestion that a hedge fund can be contrary by selling stocks short.  The evidence here is not very convincing, since even those hedge funds that are not labeled as "short only" maintain substantial short positions and use leverage.

But first, take a look at the article.

Link: This Hedge Fund Strategy Ain’t Overcrowded.

We’ve been silently skeptical of claims that hedge funds will run out of ideas. The reason is that a hedge fund can technically do anything it wants. It doesn’t have to do traditonal long-short arbitrage, or whatever is considered standard….

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Incomes and Spending Healthy, Another Measure of Inflation Decelerates, Leading Indicators Point to Further Strength

Here is a nice summary of current economic data and a thoughtful conclusion:

Link: Incomes and Spending Healthy, Another Measure of Inflation Decelerates, Leading Indicators Point to Further Strength.

– Personal Income for November rose .3% versus estimates of a .3% increase and a .5% gain in October. – Personal Spending for November rose .3% versus estimates of a .4% increase and a .2% gain in October. – The PCE Core for November rose .1% versus …

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We’re Just Wild about Barry

The end of the calendar year provides a time for reflection, assessment, and a look ahead.  As I sort through my notes and ideas, I am acting early on the resolution to post more of them in (semi-) real time for our group.  We will still collect the various threads and provide more comprehensive analyses and reports as we have done in the past.

In looking over my agenda, I see that I have several themes that will reference Barry RItholtz, and that probably deserves some explanation.

In our office, we like Barry.  We enjoy reading his work on RealMoney, one of the Cramer sites.  We enjoy seeing him on TV.  We enjoy reading his blog, The Big Picture.  We think that he is intelligent and articulate, stating his case in a most effective fashion.  We also admire the willingness to blog, since the Cramer site philosophy ended the reader comments.  (Digression:  I like the Cramer site concept, so I hope that Cramer’s staff reconsiders the feedback issue.  They are out of step with the modern trends in encouraging comments).

It just happens that, at least for the moment, we completely disagree with most of Barry’s conclusions.  Now I could try to craft a "straw-man" argument for everything I am trying to explain, but why bother when Barry is there with a strong argument for a different viewpoint.  What we say will not make any difference to him, and it will help me explain to my band of followers why we are looking for a big rally while the expert on their TV says "Dow 7000!"

Since Barry’s views change — he’s no perma-bear — and so do mine, as those who cashed in during the 2000-2001 period remember, I’m sure we’ll line up on the same side one of these days.  At the moment, however, it will take some doing.

Sneaky Street Conspiracy?

Tucked inside this recent post joining the debate on who is the bigger contrarian, is an assertion that Wall Street is tricking us into thinking the market is attractive when it is really almost 30% overvalued.  Barry Ritholtz invokes a big name, Cliff Asness,  and states that he has researched the forward earnings comparison.  This is not what Asness and his colleagues did, as they make clear in a footnote.  The problem is that most people’s eyes glaze over while reading complex research like this, despite some entertaining zingers from Asness.

Most people are not going to read the paper, so they take it on faith that people like Barry (and Mark Hulbert in his piece) are getting it right.

There are three things wrong with this interpretation of the Asness study:

  1. He did not look at forward earnings from 1871 onward because the data do not exist.  One would expect people to know this, even without reading the footnotes!  Looking at the time period where forward earnings data are available gives a dramatically different conclusion — but then it is a more bullish era.
  2. We should not care about what happened to the market or what the relationships were in 1871.  Or 1926.  Or 1956.  Or maybe even 1976.  Start with the question of whether any market relationships before the era of derivatives should still be expected to hold true.  The desire to use data that are not relevant, just because you have it, is one of the big problems in forecasting.
  3. Most importantly, prediction is, after all, about looking forward.  It seems obvious, but many forecasters miss the point.  Using trailing earnings is especially bad at a time when there is rapid growth (as we have seen for the last three years) or a sudden decline.

Those interested in this sensible notion might want to read my paper, "Should Experts Look Forward to Predict?" 

What are the odds of 2006 being a positive year?

Here’s an interesting topic from Barry Ritholtz’s site, The Big Picture.

Link: What are the odds of 2006 being a positive year?.

I just had an interesting conversation with Mike Panzner, Director of Institutional Sales Trading at Rabo Securities. Mike is a quant who has an interesting take on the markets. Assuming the SP 500 index finishes about where the markets are at the moment …

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Hedge Fund Managers and Data

In market-based activities, the errors of others present opportunities.  It is profitable to look for any aspect of analysis where many are getting it wrong.  Since hedge funds are such an important part of the current market, understanding their managers is also essential.

Understanding and interpreting government data is fertile ground.  It is especially good for me, because of my background as a former poli sci prof, government consultant, specialist in research methods, and long-time consumer of government information.

Contrast this with the average hedge fund manager.  Now don’t get me wrong.  These managers are among my best friends!  They are really smart and very talented, or they would never get a chance to run money.  Every last one of them talks a good game and has had meaningful success somewhere.

The problem is that it is a young man’s game.  (I could try to be politically correct, but it is a world of mostly men, and that is part of the point).  There is rapid burnout.  From the perspective of regular business people, the managers are limited in experience.  There is a danger in knowledge that is a mile wide and an inch deep, where you must have an opinion on everything.

We know a lot about what hedge fund managers think because they network, some of them blog, and others write columns online.  They generally want to be contrarian, fast thinking and acting, and willing to make bold moves.  A lot of confidence and machismo is de rigeur.

The idea of being contrarian is quite sound.  It is at the heart of exploiting market inefficiencies.  The irony is how to be a contrarian when all of the other managers are doing the same thing.

Disparaging government data becomes a way of showing off.  Acting like there is a conspiracy to manipulate results may seem like sophistication.  It is usually easy to find some argument and take it to the lowest common denominator.  It is very convenient to dismiss data, since it then becomes possible to argue anecdotally.  If you do not understand something, just dismiss it as irrelevant!

A hedge fund manager who really wanted to be contrarian would want to learn more about government data releases and how to interpret them.  This is the place.

The CPI as a measurement of inflation is such an easy target for pundits.  Let’s start there, but we’ll eventually look at nearly all of the government releases.

Real Estate Sucker Bet

The major problem facing investment advisors is helping clients with
asset allocation.  Your client is intelligent and engaged.  The problem
is that they are focused on what worked last year, and your job is to
help them with what will work next year.

Our company has an internal ranking of pundits and advisors.  John Rutledge is one of our good sources.

Link:  Real Estate Sucker Bet

I was on CNBC’s Closing Bell with fellow guest and old friend Brian
Westbury to discuss the housing market on Monday, July 5. Brian and I
have known each other since the Reagan White House. He’s a great guy
and first class economist–one of the most …

I’ll expand on the housing theme in future posts, but we believe Dr.
Rutledge has it right on one of the major questions.  People have the
idea that real estate cannot decline in value — a dangerous notion.