Requirements for Contrary Thinking
Consider the Alternatives
It has been said that if you can't think through a subject, you are through thinking. The contrary approach requires a person to look up and weigh the alternatives instead of taking someone else's word for it. One method is to take the prominently held consensus, whether it be financial, economic, political, social, or philosophical, and ask what may happen to change that outlook. Don't stop at the first alternative but try to think of as many plausible alternative scenarios as possible. Going through this exercise will help you recognize which one is more likely to come to pass, when some vital clues that are invisible to the unthinking majority start to materialize.
One problem that we all face is that we were conditioned at an early age to believe everything we read in our schoolbooks and hear from our teachers. As Neill put it, "We bred the habit of unthinking acquiescence rather than exercising such intelligence as we might have." Very few of us take the trouble of looking at both aspects of an argument. We either derive our opinions secondhand from what we hear or read or conveniently take the side that is consistent with our personal philosophical or political beliefs.
Don't Extrapolate the Future from the Present
Part of the process of anticipating the market's twists and turns involves assessing when the prevailing price trend is about to reverse. Most of us gain greater confidence as prices move up not only because our accounts show more paper profits helping us to feel more at ease with our financial position but also because rising prices are an apparent vindication of our judgment. Since the markets discount the good news on the way up, the longer a bull trend continues, the more positive the news background is likely to be. This makes it difficult to anticipate a turn since we all have a tendency to extrapolate from present conditions. Many market analysts get locked into models or other analytical frameworks based on previous experience and have a similar problem.
In the late 1980s, the economy experienced a long recovery that was well above its normal two- to three-year span. This led many economists to conclude that the business cycle had been repealed. The argument rested on the so-called rolling economy in which alternating regional declines would result in a selfcorrecting economy. Under such an environment, the overall growth rate for the economy would simply slow and not actually contract. A similar theory based on global economies also pronounced the international business cycle to be dead. A long recession did emerge in the middle of 1990 and 1991. In retrospect, this whole exercise had represented one of projecting what was the prevailing trend of economic recovery well into the future.
You will be amazed if you read past periodicals and newspapers how often the prevailing conditions produced the opinions of the day. The press rarely makes any effort to report things that would cause a change in the future. One exception occurs after an unexpectedly sharp price reversal has taken place. Media spokespersons, who are always looking for an excuse to justify price changes, will then say, for example, "Bond prices fell sharply yesterday because speculators were worried about the resurgence of inflation." In this example, the analysis of the future is based on a knee-jerk reaction to a price change rather than a reasoned analysis of why inflation might be a problem in the future.
We are, to a large degree, unconsciously influenced by what is taking place at the moment. If prices are rising, the bullish arguments and commentators are plastered all over the financial pages. Conversely, it is the bears who are quoted as prices plummet. It therefore becomes the job of the contrarian not to confuse cause and effect.
Remember That Events, Not People, Control the Future
In this era of public relations and "spin doctors" when people in authority are able to manipulate the news with timed announcements, photo opportunities, and leaks, there is a natural tendency to believe that personalities are in control of events. In most cases, though, it is the events that drive the leaders. External circumstances control the attitude of individuals and crowds, so it is important for contrarians to analyze events just as much as viewpoints, personalities, and sentiment.
In his famous treatise on crowds, Le Bon wrote, "A great number of historical events are often miscomprehended . . . because we seek to interpret them in the light of a logic which in reality has very little influence on their genesis." We constantly look to the government as a source of problem solving but usually find it wanting. If logic played any part in governmental decision making, the Vietnam War would not have escalated to the extent that it did, nor would the Soviet invasion of Afghanistan have taken place. Often those in power find that they have to react to events. It is how they cope with those events that separates the great from the rest of us. Sound reasoning rarely plays a part in social trends, otherwise we would have solved such problems as racial prejudice and nationalism long ago. These dilemmas are essentially the result of emotions and attitudes rather than logic. Is it little wonder that many devastating wars have arisen from religious conflicts based on beliefs rather than knowledge?
Brooks Adams, in The Law of Civilization and Decay (1897), also encapsulated this feeling in his preface: "Another conviction forced on my mind, by the examination of long periods of history, was the exceedingly small part played by conscious thought in molding the fate of men. At the moment of action the human being almost invariably obeys an instinct, like an animal; only after action has ceased does he reflect."
Humphrey Neill summed up the role of events in The Ruminator. "Events control actions and attitudes of individuals and crowds. Contrarians therefore look for the contrary guidance in the events as well as in the analysis of viewpoints, sentiment and activities of those concerned."
People Like to Conform
One reason that people grouped together act as crowds is that they love to conform. In a way, this is a form of imitation. In the 1950s, virtually every male wore short hair; long hair was considered to be antisocial. In the 1960s, many influential rock groups made long hair fashionable so that many who had worn their hair short in the 1950s now found themselves imitating and conforming by growing it long. The same sort of thing happens at committee meetings. Most people feel much safer going along with the majority so as not to rock the boat, or, in the case of corporate meetings, jeopardize their careers.
In the financial markets, we look for opinions from prominent analysts and other experts. We forget that they are as fallible as the next person. We often overlook that such people often have a personal motive for holding their views. An example of this would be the portfolio manager or strategist who is already invested in the stocks that he is recommending.
Where Do Opinions Come From?
Themes in the market and other general opinions find their origins in sudden events, a sharp move in price either up or down, or from ideas radiating slowly from a small group of opinion makers. This latter phenomenon is somewhat akin to throwing a stone in a still pond and watching the ripples spread into a widening circle. The contrarian should take advantage of this ripple of knowledge by skimming through a number of financial periodicals for an opinion that is likely to catch the imagination of the public when it spreads further.
A good source of such concentrated uniformity of opinion comes from forums or conferences. I remember attending an international conference of market technicians in October 1990. Equity markets around the world had fallen sharply that September due to the Persian Gulf crisis. Many attendees had either lost their jobs or feared a potential loss, and sentiment was among the most negative and one sided that I have ever experienced at a conference of this nature. It was difficult to buck the prevailing opinion, but as it turned out, that was the correct thing to do. The U.S. stock market, for example, was in the final throes of a primary bear trend and therefore presented an outstanding buying opportunity. One of the principal reasons for the negativism was the fear that oil prices would rise and that this would in turn result in an inflationary increase in interest rates. What happened was that interest r
ates fell because of weak economic conditions, the Fed eased in a series of cuts in the discount rate, and the stock market took off.
In the world of fashion, different styles grow and wane in popularity, and the world of buying and selling stocks is no different. Various industries become popular with investors and just as quickly lose their luster. In the late 1970s, food and tobacco stocks offered tremendous value and for the most part had very consistent growth records. Even so, they were considered to be dull and unexciting because they went nowhere. By the beginning of the 1990s, these same stocks had become "musts" in any institutional portfolio. Technology stocks were the darlings in 1983, but that was to be their peak in popularity for many years to come. It is the job of the contrarian to find the positive aspects of these groups when they are out of favor, and vice versa.
I distinctly remember reading an article on oil stocks in the financial press at the close of 1980. At the time, oil had everything going for it such as shortages and an increase in world demand. You name it and it was fully documented in the article. It was very difficult not to believe that oil stocks were headed much higher. As it turned out, that happened to be the peak in oil stocks for many years. It was necessary to look for the contrary arguments because the bullish ones had already been factored into the price. If an argument appears in the popular press, you can be sure that everyone who wants to buy is already on board. And that, if you will, is the time to look at the other side of the argument.
History Repeats, but Contrarians Must Be Careful
The study of previous market experiences indicates that history does indeed repeat but rarely does it repeat itself exactly. If we take this truism too literally, we can find ourselves in trouble, because the aspect of repeating past mistakes has to be carefully thought through by comparing the facts in the two situations. For example, people rarely repeat the same mistake on consecutive occasions because they can remember back to their last unfortunate market experience. So they vow never to make the same mistake again. In Chapter 6, we cited several examples of this phenomenon.
If the Theory of Contrary Opinion Becomes Too Popular, Will It Fail to Work?
Contrary opinion in a mechanistic sense has already become popular, but forming a contrary opinion is an art not a science so it does not readily lend itself to a mechanistic or simplistic approach. It is one thing to point to a news story and take the opposite point of view or to take the position that "everyone is bearish so I am bullish." It is quite another to see that majority opinion has solidified into a dogma for which there is no longer a basis in fact. The true theory of contrary opinion is unlikely to become widely practiced because it involves creative thinking, and most people when given the choice, prefer to follow and imitate rather than reflect.
The majority will always find it easier to follow views that appear in the papers or on the television than to think through a number of alternative scenarios for themselves. To give Humphrey Neill the last word, "The Theory of Contrary Opinion will never become so popular that it destroys its own usefulness. Anything that you have to work hard at and to think hard about, to make it workable, is never going to become common practice."
8
When to Go
Contrary
It is one thing to understand that going contrary can be profitable. It is quite another to know when to do it. In this chapter, you will find a few guideposts to point you in the right direction. These guideposts are not found easily; there is no fail-safe way to establish the exact moment when the crowd will be proved wrong. Market prices are determined by the evolving attitudes of individuals who may be either temporarily in or out of the market. The hopes, fears, and expectations of these people, and their attitudes toward those expectations are all factored into the price. Trends in psychological attitudes have a tendency to feed on themselves. In many instances, it is possible to point to a market trend that has reached what we might call a normal extreme. The widely held view appears to be well-established, and the market seems to have fully discounted this point of view; yet for some seemingly irrational reason, the movement in crowd psychology continues beyond normal bounds. More and more participants are drawn in, and this conventional view becomes increasingly solidified.
Fortunately, these extreme situations, in which normal levels of valuation and rationality are thrown to the wind, do not occur very often. The bull market of the 1920s in the United States, and the Japanese equity boom of the 1980s are two such market crazes that readily come to mind. Another example would be the spectacular run-up in precious metal prices that culminated in the 1980 blowoff. In each of these examples, rational expectations were abandoned early on, and the markets took on a life of their own before the inevitable crash. These situations demonstrate one of the key problems facing the contrarian-calling a market turn too early-in these examples, far too early.
In a way, forming a well-considered contrary opinion is similar to establishing an informal measure of market risk. When all participants agree on a specific outlook, it means that they are all positioned to take advantage of it. In the case of a negative outcome, they will already have sought protection either through a direct sale, by hedging their investments, or a combination of the two. In such instances, the odds are good that the prevailing trend will head in the opposite direction, because there are fewer people to sustain it. In those situations where the trend continues on its course, participants begin to feed on new and freshly developed arguments that help to sustain their belief in the consensus. In extreme cases, these newfound arguments combine with the allure of rapidly moving prices to entice more players onto the field.
When I was a broker in Canada back in the early 1970s, for example, no one was particularly interested in gold, which was selling for about $100 at the time. Few people understood its role in the monetary system; most were interested in stocks or bonds. By the end of 1979, attitudes had changed. Participation in the gold market had greatly expanded from the usual speculators in the futures markets. Swiss banks had heavily involved their clients, and the public was now queuing up in the banks to purchase the yellow metal. Opinion on gold as an inflationary hedge had not only solidified but had attracted and seduced a naive public into the market as well.
When the question changes from "whether" the price will rise or fall to "when and by how much," thoughtful people should consider closing out their positions. In the preceding example, that point would probably have been reached when gold was selling in the $300-$400 range. That, of course, would have been far too early, because the price eventually touched $850. However, the contrarian recognizes that it is far better to be early and right than late and wrong. Therefore, the major drawback of the contrary approach is that you often find yourself prematurely liquidating a position.
This problem is less critical at market bottoms where values are sound and prices reverse quickly. When a bearish opinion solidifies, people tend to throw stocks and other investments away at virtually any price. Moreover, sharp price setbacks tend to be self-feeding for a while, since lower prices force those with leveraged positions to liquidate. Fear is a stronger motivator than greed, so the "early" contrarian does not usually have long to wait before prices return to their break-even point. In such situations, he will have the confidence to hold on, since the purchases will undoubtedly be made at an unsustainably low level of valuation. This valuation could take the form of an unusually high dividend yield for stocks, a very high interest rate for bonds, or, in the instance of a commodity, a price that is well below the prevailing level of production costs.
Knowing when to "go contrary" then, is a difficult and elusive task. For this reason, it is best to integrate the contrary approach with other methodologies of market analysis. The degree to which a consensus becomes solidified is in a sense a measure of market risk, and what is risky can become more so before the prevailing trend has run its course. Combining the contrary approach with other approaches such as historically accepted measures of valuation
can therefore represent a useful confirmation. For example, if stocks are yielding less than 3%, interest rates have begun to rise, and the view on the street is that stocks have nowhere else to go but up, there is an excellent chance that a major peak in equities is close at hand. When valuations are high, this is another way of saying that the consensus has reached an extreme.
Determining Whether the Consensus Is at a Short- or a Long-Term Turning Point
One task that the contrarian must accomplish is to decide whether the consensus is of short- or long-term significance. For example, a recently released government report on the employment picture may indicate that the economy is stronger than most people expected. As a result, bond prices, which do not respond well to favorable economic news, start to sell off sharply. At this point, speculators in the bond market begin to get very discouraged. Not only are prices declining, but a rumor of a pickup in the inflation numbers has now begun making the rounds. The bond market declines even more. The consensus among traders has, in the space of a few days or a week, moved strongly to the bearish side. The chances are, though, that this is only a short-term top.
We do not know the details of the general economic picture from this example, but major peaks in bond prices require a lot more evidence that the economy is turning than one economic report and the rumor of a second. Such turning points are usually associated with a general belief that the economy will not recover for some time. Typically a turn has been previously but prematurely anticipated by the majority. When there is no followthrough to these initial signs, people lose heart. This "give-up" phase is often the contrarian's best tip that a recovery is, in fact, on the way.
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