CONTRARIANISM - KEY TO SUCCESS?

It takes patience, discipline and courage to follow the "contrarian" route to investment success: to buy when others are despondently selling, to sell when others are avidly buying. However, based on half a century of experience, I can attest to the rewards at the end of the journey. - Sir John Marks Templeton

Contrarianism means figuring out what the herd is doing, and doing the exact opposite. It isn't usually particularly hard to know what everyone else thinks, if people are bullish then you will hear how clever everyone thinks they are as they regale the whole party with their latest killings on the stock market and it seems that everyone you meet is into shares. When the bears are out in force people tend to look at you like you are some kind of risk-taking nut if you mention the share market, and they usually turn to happier topics, like infant mortality and the upcoming global pandemic that will destroy western civilisation.

When the market is bearish no one wants to talk about it, those few die-hards who are invested for the long term console themselves on the old propaganda that if you hold for five years all will be well, as they try not to think about the massive capital losses on their portfolios.

Contrarianism means being an anti-social fool that refuses to listen to the advice of anyone they come into contact with, it means being skeptical when the market has been bullish for a while, and it means going out and betting the bank when prices fall.

Not only investors but also speculators can benefit from a contrarian strategy. It isn't necessarily the case that the crowd is always wrong, most will be wrong over longer periods but if it was a simple matter of reading market sentiment surveys and doing the opposite then the few who do that would be hugely rich. They aren't. The advantage of contrarianism is that as a whole the market is pretty bad at doing forecasting, if we are to assume that bullish or bearish sentiment has exactly nothing to do with the future course of the market, then it means the total possible returns by going contrarian should be greater.
If the market anticipates an event such as a takeover or an interest cut, the price will rise in anticipation. The more convinced the traders are that this move is going to happen, the more it will be reflected in the share price. If 99% of traders anticipate a certain set of numbers and they are right, the price will hardly budge. What if they are wrong? The more convinced the market was of the data coming out as anticipated, and the more wrong everyone was, the greater the disillusionment when they turn out to be wrong. Although not in itself a complete trading system, certainly not something you would send money after purely on these grounds, many speculators incorporate contrarianism into their strategy, it often means if they are right they make huge profits, if they are wrong very little happens. Surveys done through brokerage firms and various web sites poll traders for their views, in almost every occasion where massive moves have been made, the crowd has been wrong, if not unanimously, then at least in the main.

The greatest caution should be advised at this point. If a stock can trade at a stupidly high price-earnings ratio of 100, then it can just as easily trade at 200. The Japanese market in the 1980s was as crooked as anything in the western world in the 1920s and soared to insane heights. It was expensive and then it got very expensive and then it got staggeringly expensive and then it had a glorious bull run. The falls that occurred later on were certainly devastating, and blind Freddy could see that the market was due for a fall, but if you had shorted the market when the prices first became unsustainable you would have lost your shirt as the Japanese citizens dutifully put their money into whatever their most influential brokers told them to. It can happen to whole markets, it can happen to sectors (often technology) and sometimes it just happens to single stocks. Contrarianism is a powerful technique but should never be blindly applied.

As far as speculation goes it works best with economic events that are hard to predict yet widely anticipated, like interest rate moves. In investment it amounts to a caution against buying just because it has tripled. Futures traders are often interested in forming views of sentiment, and keep track not only of bull/bear surveys but also open interest and volume.

Investors like Warren Buffett bypass contrarianism altogether, considering it all a rather futile pursuit to even bother with what the market thinks. He buys businesses, not stocks, as long as the price is not unreasonable the market quote means very little to him, he merely keeps a casual eye on prices to see if anything he likes is going at prices he thinks are pretty cheap.


Regression to the mean, which I discuss next article can make a potentially very profitable investment strategy. Computer analysis of the All Ords (see Sensible Share Investing by Austin Donnelly, pg. 39) shows that historically the results of the previous five years have been a fairly reliable indicator of the performance of the next five, though in a contrary manner.

If the last five years has seen an annual return of between -14.25% to 4.99%, historically the average return of the next has been 11.04%. When the last five years has returned between -5% and 9.99% then you can expect, based on the past performance of the All Ords, an annual return in the next five years of 7.57%, and historically five year annual returns of 10% to 36.13% have led to an average result in the next five years of only 4.81% per annum.

Those are averages, take a look at the downside risk, when the previous five years have shown a loss between 14.25% and a loss of 4.25%, the next five years have never in the last 50 years produced a loss, the worst case scenario has been a 4.9% per annum gain in the next five years. When the market has returned between 5% and 9.99% in the last five years though, the worst performance of the following years has been a 14.51% per annum loss.

When the market has returned 10% and 36.13% in annual gains for the last five years, the worst result was an annual loss of 14.25% for the next five years, that means that strong bull markets have tended to precede big losses, 14.25% PA lost over five years is a 46% decline in total, which is precisely what happens to most investors that watch too many of those terrible popular current affairs shows that run all those stories on housewives striking it rich in stocks, so they buy in with great confidence, comforting themselves with the knowledge that this market has produced good returns for many years, and will probably continue to do so, because crashes only ever happen in the past, and the bad old days of greedy speculators went out with the 80s...

So what are your chances of making a profit in the market, given the returns from the past five years? Well, past returns are no guarantee of future results, but if history is any guide then the chance of making a profit would be: 91%, if the previous five years have returned an annual gain of between -14.25% and 4.99%, 70%, if the market returned between -5% and 9.99% and finally if the market has returned between 10% and 36.13% for the past five years, historically you can make a profit in the next five only 41% of the time.

Contrary investment usually means selling shares when they are near historic highs in terms of price-earnings ratios and historic lows for dividend yields. It means buying right in the midst of doom and gloom, but it means you are probably buying at prices way below the average in terms of PERs and with very good dividend yields.

Value investors don't explicitly set out to do the opposite of what everyone else is doing, but do tend to buy at the same time as contrarian investors, for exactly those reasons, so if you want to be a contrarian investor you may well wish to study value investment to improve your hit ratio.

In the same book, Donnelly ran some more tests on the implications of the past five years with respect to the next. The following table is a summary of end-of-quarter results of the All Ordinaries from January 1955 to December 1993, a total of 156 rolling 5-year periods. Zone refers to Donnelly's "Zone" system, more on this later. 5 year average gain is the compound gain of the market from the previous five years. Average is the average per annum compound gains of the five years after the backtest period, worst is the worst compound gain or loss for the next five years, best is the best compound gain for the next 5 years. Volatility is the coefficient of variation, the standard deviation (sigma) divided by the mean. If you aren't a statistician this merely means that the smaller the number the more steady the prices, the larger the more wildly gyrating. Success rate is the rate of achieving at least an 8% gain in capital. He assumes that you can get 8% from risk-free investments, and so anything returning less than 8% in the share market is obviously a failure, to expose your money to risk of capital loss and make less than some guy with a term deposit account should be called a bad result.