When to be Contrarian

In investing, as well as in life, it is usually easier to follow the hordes.  Momentum and trend-following trading strategies are based upon the idea that that markets tend to move in sequential patterns for periods of time.  Investors usually find it profitable to ride long-term, secular upward trends, while traders seek to benefit from short-term moves in either direction.  Yet we all know that trends don’t persist forever.  It is quite beneficial to notice when a trend is ebbing or reversing.  Doing so requires contrary thinking.

A recent Twitter exchange with a journalist whom I respect spurred my thinking in that regard.  She offered a series of potential reversals, and although I jested that she was being quite the contrarian, I understood the logic behind her rationale.  If you believe that a certain trend is firmly in place, it is important to stress test that theory by seeing if the opposite can be true.  If, for example, you are riding a bullish move in a particular investment it is important for you to recognize what set of circumstances would cause the price to fall.  If after careful analysis those triggers seem feeble or remote possibilities, then your investment thesis is likely a solid one. If they seem plausible or likely, then it is time to consider hedging or reducing your exposure. 

Notice that I didn’t suggest bailing on your investment completely or turning from long to short.  While it is critical to continually search for turning points, it is quite difficult to actually spot them and even more difficult to profit from them.  But that hardly negates the need to look for turning points and the contrary thinking required in that search.

In a recent podcast[i], I discussed the topic of trend following with Thomas Peterffy, our firm’s Chairman and Founder, and he acknowledged this problem:

Steve

…here’s a trading question. Would you rather catch a turning point or a trend?

Thomas

I don’t think people can reliably catch turning points. I think that’s impossible. Trends are easier, but of course it’s a… how do you know when the trend turns, right? So since you can’t catch the turning point you can’t catch the trend turns. But the fact is that the look in a rising market or a falling market the next day is more likely to be like the previous day was.

That’s also, markets have serial runs. Trend followers have made a lot of money. And, uh, I do not know too many people who have consistently made money catching turns, although some chartists are very good.

Steve

OK, so it goes back to the theory catch the trend but have a defined exit. Or be careful in case the trend turns against you.

So lets’ engage in a bit of contrary thinking about some key market topics:

• Equities are ready to bounce:  By many technical measures, U.S. and other global equity indices are quite oversold, at least on a short-term basis.  Combining traders’ natural propensity for bargain hunting and the fact that many of the most powerful short-term rallies have occurred during bear markets, it would not be unreasonable to expect a bounce at some point in the near term.  But when I search for evidence of important turning points, like days when declines outnumber advances by a 9:1 basis or VIX futures trading at an extremely steep inversion, those aren’t present yet.  Today’s failed rally in early trading is another negative sign.

• Key commodities reverse:  Commodities charts have become downright scary.  Most of them are in backwardation – implying a short-term scarcity in the underlying commodity – and some, like oil and wheat, have gone parabolic in recent sessions.  Parabolic uptrends are almost always unsustainable for long periods of time and tend to reverse abruptly and sharply.  The question is when.  Parabolic uptrends imply that some group is desperate for the commodity or security in question.  In the case of stocks, that tends to resolve itself naturally.  In the case of necessities, like the commodities having the most extreme moves, supply/demand can take longer to equilibrate.  Can they reverse tomorrow?  Sure.  When will they actually reverse?  Ummm….

We could go on and on.  I offered the two examples above because those are the most pressing questions for investors and consumers alike, but this is the sort of exercise that anyone could – and should – be engaging in on a regular basis.  Hopefully your investment theses withstand a key bout of critical and contrarian thinking.  And if not, that you are prepared to adjust your exposures accordingly.

[i] You can find the rest of this podcast and the other half of our discussion – along with several other podcasts – at this link to IBKR Traders’ Insight Radio