Contrarian Investing

Psychology is the reason most investors fail to keep up with the markets, and why contrarian strategies have turned in consistently superior performance over time. This same inability to understand psychology is often why academics don’t incorporate its use and instead stay with what may be flawed modern portfolio theory. This is the major premise of David Dreman’s new book, Contrarian Investment Strategies: The Next Generation. . . . The major reason why most conventional investment approaches fall short is because predicting and forecasting is so difficult, and most people don’t recognize the limitations of forecasting. Investors typically overreact in either direction, and this is where the opportunities arise. The strategies that Dreman endorses involve the pursuit of those stocks that the experts would avoid and, conversely, to eschew those exalted favorites whose risks may be understated. In unloved companies, the risks are generally overstated. There are many dimensions of risk, and the one now in common use of equating risk with volatility is faulty. This methodology doesn’t mean to confine attention to companies that appear headed for the junk heap, but to find solid companies that for a variety of reasons may currently be in disfavor. In his book, Dreman trots out a number of studies, both old and new, that he believes illustrate the superior results of contrarian strategies over time. He also espouses a new approach incorporating relative rather than absolute valuation standards.

. . . Eric Miller, Donaldson, Lufkin & Jenrette (May 13, 1998)

We recalled Eric Miller’s quip from an era gone by while reading this from the uber smart Jason Goepfert of SentimenTrader fame:

Individual investors just won’t buy into this market. The latest AAII survey showed yet another drop in optimism. Over the past 20 weeks, the Bull Ratio has dropped to the 2nd-lowest level since the financial crisis, nearly exceeding the prior extreme from August 2012. For a year when the S&P has done very well, the average Bull Ratio year-to-date ranks among the 10 lowest all-time (chart 1).

For the contrary investor such pessimism is a clear cut “buy signal” for stocks. Indeed, we deemed the August 5, 2019 “selling climax” low to be THE low. That low of ~2822 basis the S&P 500 (SPX/2970.27) was retested three times and was never violated. Subsequently, last Monday (10-7-19) we wrote:

Provided there are not any more shocking news revelations, it looks to us like the stock market bottomed last Thursday morning (October 3). However, unlike August 5th’s V-shaped “selling climax” low this bottom should be more of a process with the potential for a few retests of last week’s low (2855 basis the SPX). Eventually, the SPX should switch back to a mildly bullish mode and move towards the all-time highs. The problem is the stock market’s “internal energy” has been used up making a rally to above new all-time highs difficult in the short run.

Later in the week we told several institutional accounts that if the upward sloping blue trendline was not violated on a closing basis the upside should be favored (chart 2). That trendline was never violated. So, what we have is the “selling climax” low of August 5th followed a “throwback rally, and then a secondary low on October 3rd at ~2855. Admittedly, our “bottoming process” did not play all that well, or for quite as long as we thought, yet it certainly looked like it would until last Friday’s Fling (+320 Dow points). For example, the SPX’s intraday high on October 3rd was ~2911 and last Thursday’s intraday low was ~2917 (read: bottoming process), but then came Friday’s Dow Wow on news of a trade deal with China. As often stated in these missives, “In secular bull markets most of the surprises come on the upside!”