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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