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Goin’ Against the Flow

30 Sep

Contrarian [courtesy Google Images]

Contrarian
[courtesy Google Images]

This article expresses some of my notions on investing–especially in relation to the “buy low, sell high” mantra.

 

MarketWatch.com reported in “Opinion: Almost no one believes the stock market will fall” that,

 

Everyone believes the U.S. stock market has reached a permanently high plateau. . . . A recent Investors Intelligence survey showed bearish sentiment is at its lowest since 1987 (13.3%). . . . short-sellers have nearly disappeared along with the few remaining bears. . . . the VIX (“fear index”) is at historic lows (near 12), which reflects investor complacency.

“Put another way, almost no one believes this market will go down.”

 

As I’ve repeatedly observed, the fundamental strategy for profiting from any investment is “buy low and sell high”. You buy an investment for $100 (when its price is low); you later sell it for $200 (when its price is high); you make a $100 profit.

Conversely, if you buy an investment for $100 (when you mistakenly believe its price is low) and later sell it for $50 (when the price is even lower), you’ll lose $50.

The theory behind the “buy low and sell high” investment strategy is obvious and simple.

In practice, however, “buy low and sell high” is complicated and hard to apply because it compels investors to:

 

1) it diligently and independently research the current and historical price of whatever stock they’re attracted to; and

2) act contrary to the “conventional wisdom” of mass of investors precisely whenever that “wisdom” seems strongest.

 

Because most of us tend to be lazy, we don’t want to “diligently and independently research” whatever investment attracts us.

Because most of us are social creatures, we’re most comfortable doing what everyone else is doing. When most everyone else is buying, we naturally tend to buy. When most everyone else is selling, we naturally tend to sell. Most of us aren’t emotionally wired to strike off on our own in violation of the strongest “wisdom” of the majority.

Because most of us are lazy and inclined to “follow the herd,” it’s actually hard for most investors to “buy low and sell high”.

However, a minority of investors are intellectually and emotionally equipped to “buy low and sell high”. They’re called “contrarians” because they often act contrary to the majority’s “conventional wisdom”.

 

•  “Diligent research” into an investment is required in order to discern whether that investment’s current price is high, low or somewhere in-between. You can’t “buy low” if you don’t know a particular investment’s price history and prospects.

Most investments rise and fall in price somewhat like a sine wave. Their prices go up for a while, then they go down, and later they go up again. In order to decide if a particular investment should be purchased, “contrarians” must first accurately discern whether its current price is unreasonably high (and therefore unlikely to go much higher) or unreasonably low (and therefore likely to go higher). If the price is already high and unlikely to go much higher, there’s not much hope of applying the “buy low, sell high” strategy to make a profit.   On the other hand, if an investment’s price is at unreasonably low levels, unlikely to go much lower, and probably headed for a significant price rise—that’s a candidate for applying the “buy low, sell high” strategy to making a profit.

All of which is easily said, but hard to do.

In practice, lots of factors come into play: the world economy, the national economy, the market for whatever product or service is provided for the particular investment, and even whether the Federal Reserve will continue to hold down interest rates or actually stop QE.

The first step in “buy low, sell high” is to discern for yourself whether today’s price for a particular investment is unreasonably high, unreasonably low or reasonably in-between. You’ll have to figure it out for yourself because the essence of the buy low, sell high strategy is to be a “contrarian” and dismiss majority opinions as almost certainly mistaken. That means you can’t rely on other peoples’ judgment. You have to be able to think for yourself. If you’re going to do what the vast majority does and believe what the vast majority believes, you will almost certainly lose your assets.

Of course, if you can find one or more good contrarian gurus to follow, you might not have to do all of your own research. But, in the end, the great investors, the most profitable investors, tend to heed their own counsel and distance themselves not only from the majority, but also even from rank-and-file contrarian gurus.

 

•  “Buy low, sell high” is a perfect strategy for unemotional computers, but it’s a terrible strategy for people with dependent personalities who are scared to death of acting in opposition to the herd. Most investors would rather lose their investment than risk being seen to defy the herd’s sentiment. They’d rather lose with the “herd” than profit on their own.

If we’re going to “buy low,” we must buy at a time when majority agrees that our particular investment is not merely low-priced, but virtually worthless and unlikely to rise in the foreseeable future. We “buy low” when the majority is unreasonably convinced the particular investment can’t rise.

Thus, to “buy low” we must be a contrarian who habitually bets against the majority’s sentiment.  The more people who agree that an investment is going up (or down) the more likely they are to be wrong. I.e., when 55% agree that a particular investment is going up (or down) they might be right, they might be wrong. Hard to say. But when 90% agrees that a particular investment is worthless and should be shunned, that investment is probably at or near its lowest price and (assuming other fundamentals are present to make that investment worthwhile) should be purchased. The higher the percentage of people who believe that an investment is going up (or down), the more likely they are to be mistaken.

 

•  After you’ve done your due diligence and determined for yourself that a particular investment’s price is unreasonably low, you buy. You’ve completed the first requirement for making a profit: you bought low.

Then you must exercise the second (unspoken) element of making a profit: you wait. You wait patiently until the price on your investment begins to rise and, ideally, reaches its ultimately unreasonable “high”. That’s when you “sell high” and take your profit.

But there’s a problem with patience. Most of us don’t have much. We want what we want and we want it now. We have trouble waiting patiently because we don’t know for sure when our “sell high” profit opportunity will take place. Patience instills doubt. While we wait, we can lose confidence in our original “buy low, sell high” research. We lose our nerve and are tempted to sell low rather than wait for the “sell high” moment. Our mathematically undeniable formula (buy low, sell high) succumbs to our fears.

But if we have patience and confidence in our original decision to “buy low,” we can wait until the price of our investment rises and we can (finally!) sell high.

Of course, if we truly “sell high,” we’ll be selling at a moment when 90% or more of investors agree that the price can only rise higher. The price is high because the vast majority of investors believe that the price can only go higher. To “sell high” means that, once again, we act as contrarians and go against the flow (which makes most of us uncomfortable). We sell when virtually everyone else is convinced that a particular investment can only go higher and can’t possibly fall. We defy the majority’s “wisdom”.   Doing so makes us nervous.

 

•  Today, when stock market indices are generally at record highs, studies indicate that 87% of investors are convinced that the markets can only go higher. That majority sentiment gives investors great confidence and comfort in their stock buying decisions.

However, that 87% figure is also exactly the sort of exaggerated, unreasonably sentiment that normally precedes a significant decline. When 87% believe a record-high price is going higher, you are almost certainly at or near a “sell high” moment.

 

•  Conversely, when 51% of investors believe an investment will go higher and 49% believe that investment’s price will fall (or vice versa), we actually have a fairly accurate price for that investment. So long as investor sentiment is about 50/50—half bet long, half bet short—you may not know if the market is going up or down, but you can be confident that there will be no drastic change in price, either way. It might go up a little. It might go down a little. But the price set by a 50/50 split in investor sentiment will be roughly correct at that time.

That’s the purpose of the Free Market: to “discover” a fair price—one agreed to by both buyers and sellers—by finding a price point that half think is a good buy and half think is a good sell.

 

•  However, as investor sentiment becomes increasingly polarized (say, to a 90% versus 10%), you can bet that the majority sentiment is wrong, and that the investment’s price is due for a major “correction”.

More, you can bet that any significant investor sentiment polarization is due to some extreme and artificial stimulus that’s affecting the investment or market. That “stimulation” could be “hype” promoted by one investment firm or another. That “stimulation” could also be the result of some distortion in the supply of currency or interest rates being caused by the Federal Reserve or national government.

Today’s 87% confidence in the stock market almost certainly signals that the record-high market prices are irrational, unjustified and about to fall. It appears to be a “sell high” signal.

 

•  The MarketWatch.com article continued:

 

“No one believes the bears’ Chicken Little doom-and-gloom warnings. . . . The market has shrugged off multiple geopolitical problems, low market volume, trillions of dollars of debt, sky-high sentiment, extreme P/E ratios for many high-flying stocks, and dozens of other red flags. Yawn. The only gorilla in the room that matters is the Fed.”

 

To say that the “market has shrugged off multiple geopolitical problems, low market volume, etc. is like saying a meth-amphetamine addict has “shrugged off” the need to sleep.   What we see in today’s markets can’t be ignored as mere evidence of anything as casual as “shrugging”. As with the meth-addict, today’s markets’ extraordinary “shrugging” can only result from some gross distortion of reality.

As for the Fed being the only remaining “gorilla,” that’s true. The Federal Reserve is the Great Manipulator, the Manipulator of Last Resort, the economy’s 800-pound “gorilla”.   The Fed has become the primary “reality” in our markets. But is the Fed’s manipulation “real” in the sense that it can be sustained—or is the Fed’s manipulation only temporary, illusory and unsustainable?

•  Nearly 90% of American investors currently believe the stock market can only rise. They’ve held that belief because they also presume that the Federal Reserve’s “life support” for the stock markets can’t and won’t be significantly curtailed.

But is that presumption true, false or even irrational?

The Fed’s stock market life support system has worked something like this:

1)  The Fed printed trillions of dollars to give to banks as Quantitative Easing (QE) under the pretext that the money would be loaned to ordinary Americans who’d spend the borrowed money to purchase new cars, new homes and flat-screen TVs and thereby stimulate the economy.

2)  The Fed also suppressed the interest rate to irrationally low levels under the pretext that the low interest rates would entice ordinary Americans to borrow money from the banks and spend it on cars, homes, and TVs to stimulate the economy. However,

3)  In the midst of the “Great Recession” ordinary Americans refused to go deeper into debt and stopped borrowing money from banks.

4)  More, banks weren’t genuinely interested in lending money to ordinary Americans at irrationally low interest rates because: a) the banks couldn’t make much profit off the loans and, b) during the “Great Recession,”ordinary Americans were more likely to default on their loans. If the ordinary American defaulted on their loans, banks not only couldn’t make a profit, they’d lose their principal. Therefore banks didn’t really want to lend to Joe Sixpack.

5)  But, banks were eager to lend money to major corporations because major corporations were less likely to go bankrupt and default on their loans

6)  Plus, irrationally low interest rates made it profitable for major corporations to borrow money.

7)  The problem was that major corporations had little interest in buying cars, homes and flat-screen TVs in order to stimulate the economy. Instead, those corporations borrowed “cheap money” (low interest rates) from the banks to buy back stocks in their own corporations. These major corporations knew if their own stock had a high probability of generating a profit that would exceed the inflation rate. A significant portion of the QE trillions of dollars (that were supposedly intended to be loaned to ordinary Americans to buy products that would stimulate the economy) were actually loaned to major corporations that invested in the stock markets.

8)  Result? The Fed’s QE policies did relatively little to directly stimulate the economy, but did a great deal to stimulate the stock markets. Based on QE, corporations borrowed, corporations bought stocks, and stock market indices therefore rose to record highs. This rise was “artificial” and “unreasonable” since it was primarily fueled by the artificial stimulus provided by QE.

9)  Prognosis? As the Fed stops printing additional billions of dollars each month, the supply of QE dollars available to lend to major corporations will wither. That’s already happened with “tapering”. More importantly, when the Fed finally raises interest rates, corporations will no longer have access to “cheap money” and will slow or stop borrowing to buy stocks. When corporations stop buying stocks, there should be a major stock market “correction”. Some guru’s predict that this correction could cause markets to lose 30% or more of their currently-perceived value.

10)  When will we see the correction? Who can say? But, insofar as this correction: a) could be triggered by rising interest rates; and b) this is an election year; then, c) you can bet that the Fed will not begin to raise interest rates until sometime after this November’s election. Interest rates might begin to rise as early as December or, more likely, first quarter of next year. Once it’s clear that interest rates are rising and will continue to do so, corporations will stop borrowing “cheap money” to buy stocks, demand for stocks will decline and stock market indices should fall.

Most of the 87% who currently believe that the bull markets for stocks will never end don’t know it, but they’re basing that belief on the underlying presumption that the Federal Reserve will never stop or reduce QE.

It’s no surprise that this 87% doesn’t understand the Fed’s role in stimulating stock market prices. Because this 87% are not “contrarians,” they don’t recognize a need to study the fundamentals underlying their investment decisions. All they need to do is “follow the herd”. Because they don’t study to discover the intrinsic value of whatever investment they’re purchasing, their only economic indicator is other peoples’ actions. They view investing as a popularity contest wherein the best investments are deciding by simply voting and without regard to intrinsic value.

If most people are buying, the 87% will follow and cause stock prices to rise to unreasonable highs. If people begin to sell, the 87% will not only follow but also cause a panic that will cause stock prices to plummet to an unreasonable “low”.

“Contrarians,” on the other hand, will wait patiently, knowing that the “herd” will be every bit as over-emotional, ignorant and unreasonable when the price of stocks plunge as they were when those same stock prices soared. When the “herd” pushes stock prices to an unreasonable high, that’s the contrarians’ “sell high” moment when they can capture profits. When the 87% pushes stock prices to an unreasonable low, that’ll be the contrarians’ “buy low” point where they begin another investment cycle.

Contrarians are neither bulls nor bears. They aren’t optimists or pessimists. They are objectivists who study particular investments and public sentiment and invest accordingly. They’re also people who regularly profit from their investments. They know that the majority’s sentiment—especially a large majority like 87%—will be wrong almost every time. Therefore, the contrarians always seem to “go against the flow”—especially when that “flow” is strongly up or down.

Contrarians understand that whenever an investment’s price is far from a 50/50 split between bulls and bears, that price is due for a correction. The stronger the majority’s sentiment, the stronger the polarization between bulls and bears (say, 90% versus 10%)—the more likely that the majority is wrong and the coming correction will be dramatic.

Today’s contrarians understand that QE has stimulated the stock markets rather than the economy. Today’s contrarians believe that the Fed can’t hold interest rates down indefinitely. Contrarians know that once interest rates begin to rise, the stock indices should fall dramatically. They also know that once the fall begins, the “herd” will not merely sell, but also panic and probably push prices down to levels that are breathtakingly low.

If you accept the idea that only contrarians (those who go against the flow) tend to profit from the markets, and if you can see that majority sentiment is polarized in favor stocks and against gold, then you should recognize that stocks are near a “sell high” moment while gold is near a “buy low” moment.

It takes some intelligence to understand the “buy low, sell high” strategy. But it also takes courage.

If you have sufficient intellect and courage to be a contrarian, you could profit in today’s markets by “goin’ against the flow”.   On the other hand, if you lack either the intellect or courage required to be a contrarian, you may soon lose much of your investments.

 
7 Comments

Posted by on September 30, 2014 in Economy, Investment, stocks, Values

 

Tags: ,

7 responses to “Goin’ Against the Flow

  1. wholy1

    September 30, 2014 at 2:27 PM

    What do most “Traders / OPM persons” contribute to the “general prosperity” from any sort of productive activity? Are “they” not just another form the “money changers”? Is the sense of a “Quickening” not palpable?

     
  2. Toland

    September 30, 2014 at 3:22 PM

    Al, thanks for drawing attention to this topic. This goes beyond the “theories” we like to discuss here. People’s futures, even their lives, depend on an honest appraisal of available data from an objective point of view – meaning without the undisclosed conflict of interest of so many disreputable advisers.

    While the stock market may seem unsustainably high right now, the favorite index used by fund managers and other professionals tells a different story. These people, who look at fundamentals, consider a stock’s price-to-earnings ratio as the most important indicator of its value.

    Definition of price-to-earnings ratio by Investopedia: “A valuation ratio of a company’s current share price compared to its per-share earnings.”

    This classic fundamental indicator is of critical importance to any competent value appraisal. So much so that anyone promoting a stock who fails to address its price-to-earnings ratio is either an ignorant hack or a dishonest shill with an undisclosed conflict of interest. Either way, he shouldn’t be trusted.

    At the following site you can see the current price-to-earnings ratio of the S&P 500 in terms of a historical chart from the 1870s to present. As of now, this index is on the high side, but it’s been higher for most of the last 20 years.

    http://www.multpl.com

     
    • skybluehigh

      September 30, 2014 at 4:17 PM

      Toland, follow the P/E ratio chart in the link you posted back to about 1925. Do you see a very similar set up going into the late twenties to the set up right now? By your logic and trust in P/E ratios, you would have lost your ass by 1933. P/E ratios create another rigged stat to dangle in front of the lemmings.

      A true contrarian (involves due diligence and patience) takes profit consistently.

       
      • Henry

        September 30, 2014 at 4:54 PM

        Toland is referring to current market conditions only: starting about 1990. Ignore the ancient data, which is now obsolete since market dynamics have changed so radically in recent years.

        The chart itself is proof that the rules have changed. The market has established a 20+ year track record of tolerating PE ratios higher than what we have right now, which didn’t used to happen.

        So we see that the market is not overpriced, in modern terms.

         
      • skybluehigh

        September 30, 2014 at 5:08 PM

        Spin it however you’d like, Henry. True fundamentals haven’t changed enough for me to tolerate these higher P/E ratios.

        Think about what a P/E ratio actually indicates. It says that a dollar out today will take 20 (almost) years to come back. That’s not a great ROI considering time value of money.

         
      • skybluehigh

        September 30, 2014 at 5:37 PM

        …and one more fly in the ointment to consider:

        If not for the borrowed funds the companies used to buy back their own shares, the current P/E ratio would be much higher.

        When a company uses profits to buy back it’s own shares, then that company’s financial statement actually improves.

        When a trick is used to manipulate numbers, the financial statement moves closer toward la la land.

         
  3. skybluehigh

    September 30, 2014 at 4:56 PM

    Here’s an interesting observation:

    According to Kitco, all the precious metals AND all the indexes closed down…in the red…today. They don’t go the same direction for long.

     

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