Anyone who stops to think about it knows that the fundamental strategy for generating investment profits is to buy an investment when the price is low and sell when that investment’s price is high. The name of that strategy is “buy-low/sell-high”. The difference between the “buy low” price (say, $100) and the “sell high” price (say $300) is the measure of the profit ($200, in this example) made on the investment.
No one seeking investment profits can refute the “buy-low/sell-high” strategy. On considering that strategy, virtually everyone will say, “Well, of course,” or “Obviously” or even “Well, duh”.
However, the buy-low/sell-high” strategy isn’t as simple as it sounds. There’s a problem: investors like to behave like herd animals. We are generally and genetically afraid to act independently. We feel more comfortable believing someone else (especially an “expert”) than we do in trusting our own eyes and ears. Insofar as that tendency is prevalent, investors are prone to ignore the buy-low/sell-high strategy and instead “buy high” (when virtually everyone is buying and says “now’s the time to buy”) and “sell low” (when virtually everyone is selling at a low price). This “sell-low/buy-high” strategy is a sure formula for going broke. I.e., most investors tend to “buy high” (when the investment’s price is $300) and “sell low” (when the price is $100) and thereby suffer a $200 loss.
It’s sad that most investors tend to buy high and sell low. But, on the other hand, the silver lining in that investment tendency is that the average investor’s losses comprise the profits reaped by the minority of investors who are sufficiently smart, disciplined and perhaps lucky to “buy low and sell high”.
• The “contrarian” investment strategy is simply an enhanced explanation of the buy-low/sell-high strategy. This explanation recognizes the conflict between most investors’ “herd mentality” and the buy-low/sell-high strategy.
This investing conflict is similar to the “nature/nurture” dilemma. It’s our “nature” to follow the herd and do what the rest of the herd is doing at any moment. It is our “nurture” (actually, our education and individual character) that helps to ignore the herd and instead react objectively to market fundamentals.
In fact, the contrarian investment strategy doesn’t really “ignore” the herd. It pays close attention to the “herd” but doesn’t follow it. Instead, contrarian investors use the herd’s sentiment as a fundamental indicator of how not to invest. The contrarian’s fundamental strategy assumes that investors majority are populated by a “herd” of sentimental fools. Therefore, contrarians reject whatever a significant majority of investors are doing.
• According to Wikipedia,
“Contrarian Investing is an investment strategy that is characterized by purchasing and selling in contrast to [contrary to] the prevailing sentiment of the time.
“A contrarian believes that certain crowd behavior among investors can lead to exploitable mispricings in securities markets. For example, widespread pessimism about a stock can drive a price so low that it overstates the company’s risks, and understates its prospects for returning to profitability. Identifying and purchasing such distressed stocks, and selling them after the company recovers, can lead to above-average gains.
“Conversely, widespread optimism can result in unjustifiably high valuations that will eventually lead to drops, when those high expectations don’t pan out. Avoiding (or short-selling) investments in over-hyped investments reduces the risk of such drops. These general principles can apply whether the investment in question is an individual stock, an industry sector, or an entire market or any other asset class.”
In fact, the contrarians’ “general principles” not only apply to individual stocks and “entire markets”—they can also apply to national and even global economies.
Whenever a significant majority of investors are optimistic and engaging in herd behavior (buying because virtually everyone else is buying rather than because of investment fundamentals) contrarians see that majority sentiment as a good indication that the investment’s price is about to fall—and therefore, it’s time to sell that investment at its currently-high price. (Sell high.)
On the other hand, whenever a significant majority of investors are pessimistic and engaging in herd behavior (selling because everyone else is selling rather than because of investment fundamentals) contrarians regard that majority sentiment as a good indication that the investment’s price is about to rise and therefore, it’s time to buy that investment at its currently-low price. (Buy low.)
• Contrarians are not “democratic”. They don’t believe the markets can be ruled by the majority vote (sentiment). Instead, the contrarians act on the principle that the greater the magnitude of majority sentiment, the more certain that the majority are wrong and are therefore about to lose their assets.
For example, if: 1) 75% of investors are optimistic that a particular investment’s price will continue to rise; and 2) there’s no fundamental reason for that investment price to rise; then, 3) it’s virtually certain that the price is about to fall; and 4) contrarians will sell that investment at its high price to avoid the coming losses.
But, let’s suppose that: 1) only 60% of investors are optimistic that a particular investment’s price will keep rising; and, 2) there’s no fundamental reason for that investment price to keep rising; then, 3) it’s highly likely that the price is about to fall; and 4) contrarians will probably sell that investment at its high price to avoid the coming losses when people are forced to “sell low”.
However, what if there’s only a 51% majority who are optimistic and a 49% minority who are pessimistic? Under those circumstances, the difference between the number of optimists and number of pessimists is too small to provide a reliable guide for contrarians’ investment decisions.
The bigger the majority, the more reliable the contrarian indicator.
“Some contrarians have a permanent bear market view, while the majority of investors bet on the market going up. However, a contrarian does not necessarily have a negative view of the overall stock market, nor do they have to believe that it is always overvalued, or that the conventional wisdom is always wrong. Rather, a contrarian seeks opportunities to buy or sell specific investments when the majority of investors appear to be doing the opposite, to the point where that investment has become mispriced. While more “buy” candidates are likely to be identified during market declines (and vice versa), these opportunities can occur during periods when the overall market is generally rising or falling.”
Most investor are taught that the primary “purpose of markets” is to “discover” prices. I disagree.
I believe that the primary purpose for markets is to reach temporary agreements on prices. When 51% of investors say the asking price for an investment should be $100 and 49% say the bid price should be $99, we have a very close agreement on what the price should be. The price is temporarily “established” and, barring surprises, unlikely to change significantly in the near future. In the midst of such general “agreement,” contrarians find little basis to predict that the investment’s price will suddenly soar to $200 or plunge to $50.
Figuratively speaking, it’s when 70% of investors say the asking price should be higher (say, $110) and only 30% say the the bid price should be lower (say, $95), that we see that there’s no fundamental agreement on prices or fundamentals. The $15 difference in proposed prices is largely based on psychological sentiment rather than objective fundamentals.
70% say the price should be higher; 30% say it should be lower. No agreement. Price is disputed. Most of that dispute is based on sentiment rather than fundamentals. Sentiment is unreliable. In the midst of such sentiment-driven disagreement, contrarians can pounce. Contrarians can reject majority sentiment and, within reason, invest contrary to whichever way the majority sentiment points.
• When seeking to predict where the entire economy is heading, contrarians will look for measures of public sentiment. When 51% are optimistic and 49% are pessimistic, the economy should remain stable until some fundamental surprise causes ratio of optimists to pessimists to change significantly.
For example, if a new president is elected, the ratio of optimists to pessimists might change from 40/60 to 70/30 as the people express their hope (a sentiment) that the economy will improve dramatically and quickly under the new president. Without more, such market changes may be based primarily on psychological sentiment (exactly as seen in the economy’s recent “Trump bump”).
However, if it’s discovered that the new president can’t quickly deliver all of the improvements he promised, whatever increases have been seen or are expected in market prices will disappear. Inevitably, fundamentals will overcome sentiment and prices will fall back into a more normal, “agreeable” range where pessimism and optimism are more or less 50/50.
• The Associated Press recently reported (“US consumer confidence hits 16-year high”) that:
“U.S. consumer confidence climbed to its highest level in more than 16 years, a strong gain for one of President Donald Trump’s preferred economic indicators.”
“Consumer confidence” is a measure of sentiment. Without increasingly positive fundamentals, that sentiment is destined to wane. When such sentiment is at record-high levels of optimism, a sentiment-correction and subsequent bear market are likely. The higher the sentiment, the more likely a significant a correction will occur.
Today, we see the highest level of consumer confidence in 16 years. Tomorrow, we might see the highest level in 20 years. As consumer confidence rises, so does the probability of a significant and sudden economic “correction”.
“The Conference Board said Tuesday that its consumer confidence index rose to 125.6 in March from 116.1 in February, the best reading since December 2000. The index measures both consumers’ assessment of current conditions and their expectations for the future. Both improved this month.”
First, if the contrarian strategy is valid, then the “best reading since December 2000” is probably not evidence that the Dow is going to 30,000. It’s more likely to be evidence that the Dow is heading for 15,000.
Second, if the contrarian strategy is valid, it follows that “consumers” usually succumb to herd psychology and therefore tend buy high and sell low. In other words, “consumers” are usually idiots. They don’t invest because an investment is fundamentally and objectively sound. They invest because most other consumers are also investing based on sentiment rather than fundamentals.
“The consumers’ ‘renewed optimism suggests the possibility of some upside to the prospects for economic growth in the coming months,’ said Lynn Franco, director of economic indicators for the business group.”
Ms. Franco’s word choices (“suggests,” “possibility” and “some”) faintly imply that she’s a closet contrarian who wants to conceal her bias from the public. To me, her language indicates that she wants the idiot-consumers to continue to buy in the high-priced markets—even though she believes the “consumers’ renewed optimism” almost certainly signals the onset of a bear (rather than bull) market. Therefore, she seems to be simultaneously encouraging consumers to rely on optimistic sentiment to “buy high” while she covers her backside with the worlds “suggests,” “possibility” and “some”. If a correction suddenly occurs that forces consumers to sell low, she can always say that her word choice exempted her from charges of misleading investors.
In the end, all Ms. Franco really said was that there was a “possibility” that sentiment could push markets higher. Of course, that’s true. There’s always a “possibility” that market indices could rise higher. However, if she’s a real contrarian, she’s probably betting against such a rise.
Ms. Franco may view the public’s growing optimism as unwarranted. But, as a contrarian, she may be trying to encourage consumer optimism while she sells her investments to idiot consumers at high prices.
This hypothetical relationship between Ms. Franco and ordinary consumers illustrates both the essence of the contrarian strategy (buy low and sell high) and that strategy’s fundamental obstacle (you have to invest contrary to herd sentiment).
Every investor wants to profit. Therefore, every investor must try to buy low and sell high. That’s obvious.
But, in order to “buy low,” we must purchase an investment when the vast majority of consumers are pessimistically screaming “sell, sell, sell!” Likewise, to “sell high,” contrarians must do so when the vast majority of consumers are overwhelmed by optimism and are therefore screaming “buy, buy, buy!”
But it’s hard to invest contrary to prevailing public sentiment. Most consumers want to run with the herd. If everyone else is buying, we buy. If everyone else is selling, we sell. It doesn’t always matter to consumers that by letting the herd be their investment guide, consumers will buy when prices are high and sell when prices are low. It doesn’t matter to most consumers that using sentiment to guide their investments guarantees that most consumers will lose their assets. Most people are so much more comfortable “running with the herd” that they seem to subconsciously prefer to lose their investments rather than defy prevailing consumer/herd sentiment.
• Despite the apparent validity of the contrarian strategy, not many people can be contrarians since that strategy relies on defying public sentiment. Only a very strong few (or psychopaths) are willing and able to habitually invest contrary to the majority’s sentiment. We’d rather be “one of the guys” who also lost our assets when the herd lost its assets, than be seen as an oddball (contrarian) who profited by defying the consumers’ majority sentiment.
And yet, that defiance is absolutely necessary to make profits.
Whenever an investment reaches a record high, it inspires maximum optimistic sentiment at roughly the point when the price must inevitably begin to fall. Whenever an investment reaches record lows, it also inspires maximum consumer pessimism. Contrarians know that the most opportune to buy is when the price is at a record low—and the vast majority of consumers scream “sell!” Likewise, the most opportune time to sell is when the price is at a record high and the vast majority of consumers scream “buy!”
We can know when prices are at or near maximum highs (and it’s time to “sell high”) when consumer sentiment is at its highest level of optimism. We can know when prices are at their minimal lows (and it’s time to “buy low”) by measuring when consumer confidence is at its most pessimistic.
This isn’t news. In A.D. 1871, Baron Rothschild observed that the best time to buy investments was when the “blood was running in the streets”. That “blood” would correspond to a moment maximum public pessimism and maximally-low prices.
Baron Rothschild got rich being a contrarian.
• The contrarian strategy is fundamentally simple. You buy low and sell high.
But the contrarian strategy is also fundamentally hard to implement because, in order to maximize your profits, you must ultimately invest contrary to the majority of public opinion. Most of us find it extremely difficult to run against the herd—but that’s what the contrarian strategy requires.
The contrarian strategy is also uncomfortable because it’s based on the presumption that the majority of consumers are idiots. Most of us don’t want to regard the majority of our fellow men as idiots. We want to presume that our fellow men are (just like you and me) wise, hard-working and noble (despite much evidence to the contrary).
Contrarians are essentially anti-social. They watch for the moments when consumer majorities appear and then bet against the “herd’s” prevailing sentiment. Such defiance wears on us. Surely, there must be a way to profit from investing without being anti-social. Right? . . . . Right?
• “Economists closely monitor the mood of consumers because their spending accounts for about 70 percent of U.S. economic activity.”
Bunk. Economists don’t monitor the consumers’ mood primarily because their spending constitutes 70% of of the economy. They monitor consumer “moods” (sentiment) primarily because most consumers are idiots. Even so, consumers are “useful idiots” since whenever they start behaving like a herd and investing based primarily on majority sentiment rather than objective fundamentals, they‘re almost always wrong. Whenever a significant majority of consumers say “Yes,” contrarians bet that the correct answer is “No”—and the contrarians usually win.
Why? Because consumers are greedy, fearful and ignorant. They want more profits, but they’re afraid to act based on their own thinking and research. They don’t trust their intelligence or their education and therefore, they’re unwilling to act on what they personally see and prefer to act based on what the herd says. In the midst of their fear, ignorance and laziness, consumers refuse to study and rely on fundamentals and instead rely on doing whatever the other consumers are doing.
By doing so, the consumers’ investment strategy may be “politically correct”—but they’re also sure to lose their assets.
• So, assuming that the contrarian investment strategy is valid, what should we make of recent reports that consumer confidence (sentiment) is at a 16-year high?
Is that confidence evidence that market indices like the Dow are certainly destined to soon go higher (22,000) and higher (25,000)? Is that consumer confidence evidence that gold will fall to $700?
Or is that record-high confidence evidence that we’re at a market peak and all the smart folk (contrarians) who invested in the Dow should be “selling high” and “buying low” in gold?
If the answers to those questions aren’t fairly obvious to you, odds are you’re primarily a “consumer”.