Daily Speculations

Spec Forum:

Contrarianism

August 2003

Omid Malekan:

Recently I have been thinking a lot about the contrarian approach, and have

come up with three obstacles that need to be overcome. For my purposes, I

define being a contrarian as going against a trend which has already sucked

in a large percentage of those who would play that trend, leading to a turn

in prices.

The first obstacle is determining what percentage of the players have

already taken a certain position. There are many indirect indicators to look

at, but no measure that I have seen is perfect. Volatility makes major

regime shifts over the years, options analysis could be skewed by hedging

strategies, and anecdotal evidence is just that, anecdotal. Surveys tell us

what people say, which could be very different from what they actually do.

Besides, if a perfect measure of "who is long and who is short" did exist,

widespread knowledge of it would eliminate its usefulness.

The second hurdle is picking a level to mark as an extreme. A cab driver

recommending GE may be a sign, but wouldn't 2 cab drivers be a bigger sign?

With the quantified sentiment measures statistical analysis makes the most

sense, but by definition major inflection points are rare, making purely

quantitative analysis shaky. My own experience has been that betting against

a VIX of 50 when it ends up topping out at 70 could be devastating when real

world constraints are taken into account, even if soon enough the index is

at 30.

But it's the final hurdle that bothers me the most. Markets are an extremely

open system in the long term, and a major move in one direction could be

self replicating in the short term. One cab driver recommending a stock that

has had a big run may be a sign, but what about the thousands of other cab

drivers who at the moment have no opinion of the stock. Couldn't another 10%

increase in the stock suck them in to buy, leading to a greater number of

cab drivers who are bullish on it? And couldn't the news of the profits of

the cab drivers eventually lead reluctant valuation based traders who are

lagging the stock in YTD returns to go long, all the while creating further

upside that makes shaky contrarians like myself throw in the towel?

I am certain that this territory has been covered before, and I have a

feeling that a system which is self-defeating below a certain magnitude but

self-fulfilling above it exists in the physical sciences, though I cant

think of any at the top of my head. Advice on where to take my investigation

is well appreciated.

Kim Zussman:

Contrarian examples are easier to see in hindsight than contemporaneously.

For example, the big sell-off in March just before the Iraq war: Generalized

fear about the outcome, another Vietnam, etc sent stocks south and VIX up.

Looking back, this was an excellent buying opportunity ( I bought a bit

then, with much trepidation after experiencing the prior 3 year bear).

I agree that markets are open (relatively unbounded) over long periods,

which at some level must contribute to the risk participants are taking.  In

1996, Greenspan's "Irrational Exuberance" speech was prescient but 4-years

early.  Shiller's work suggests mean reversion of stockmarket when PE's are

too high, and has over 100 years of data to support.  Yet the trend

continued with vigor in 1990's, making poor those who bet on mean reversion.

To the extent that markets are at least partially efficient, VIX and VXN

should not be reliable indicators (and should become less reliable over time

as investors seek to exploit).

Let's say finance academics show in a series of (statistically valid) papers

that buying the market at VIX (or VXN, etc) over X results in positive returns

over 1 year:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=371461

These papers circulate to all the hedgies and investment houses who pay PhDs to

capitalize on anomalies.  The houses in turn trade heavily according to these

findings.  Will VIX based buying remain profitable?  If VIX is an indelible

indicator of risk, then buying at a certain level should proscribe high

probability of either loss or gain, without knowledge of which.  If high VIX

were an immutable indicator of profitable long entry, smart would buy (earlier

and earlier) and the indicator would not indicate.

IMO contrarian buy or sell signal points should be very difficult to identify

contemporaneously, otherwise they would be exploited by (all you) smart money

and would not form global minima and maxima. If you were around in 1987, how

would you know to throw in at the vertiginous convulsion (and the largest drop

since the great depression)?  And even if you had some indicators, what about

the guts?  Bail out 3/00?  Why not?

James Lackey:  

I have never lost more money than going against what I thought everyone already

knew.  I have never missed so many opportunities, thinking that everyone knew,

so I was too late.  I have never lost more opportunity by taking small profits

in what I thought was to sell the news as now everyone knows.

All that is retrospective, qualitative. But a close second is trading to get

even...and when I did I sold only to see the price rise 10-fold again...LACK

Mark Serafini:

Contrarianism is best performed in a context where the market is in the

process of creating a self-fulfilling/self-defeating paradox.  Once you locate

those environments, you can then wait for the market to behave in a counterintuitive

manner...at that point in time you have found yourself a true contrarian

opportunity.

Omid Malekan:  

Assuming the spec-list represents a fair cut of the investment world, much

can be learned from the recent discussion of contrarianism. Many of us admit

to the approach, and more importantly we all take a certain pleasure in it.

In my brief years of interaction with traders I have met many people who are

and love to talk about being a contrarian but I haven't met many who talk

with the same glee about just following the trend. I know there are many

trend-followers, but not many of them seem to get the added pleasure that

contrarians do just from their approach. I believe this comes from the fact

that if you are a good contrarian not only are you making money, but by

definition you are making money when the majority or "the crowd" is wrong

and thus losing money.

Now we have hit a trap. The first lesson most traders learn is how dangerous

trading for any other reason other than to make money is. And as much as

most traders will agree with me on this, most of us end up doing a trade for

external reasons (having a bad day, wanting to recoup losses, meeting a

certain profit goal, paying the rent) sooner rather than later. I submit

that being a contrarian should be added to the list. Why is it that most of

us usually complain about being early vs getting in too late? Does it have

something to do with wanting to pick the exact top, the points where the

greatest number of people are wrong? 

I still see much value in the approach, but now believe that many of us are

contrarians because we get certain satisfactions, not necessarily because we

are good at it and make money. 

Daniel V. Grossman

Omid, I recognize a similar tendency in myself, but would analyze it an an unfortunate "perfectionism".

Thus if I make two trades on a day:

1. I sell 1000 shares at the high (or within a cent or two of the high) for

the day, after which the stock drops significantly.

2. I sell 2000 shares not near the high for the day but making twice the

profit.

I would probably have stronger thoughts about, get more pleasure out of, the

first of these trades, because would demonstrate to myself how smart I was,

how my thinking and instincts were so perfect that I was able to get out at

the high.

Is this familiar to anyone, or is it solely my own counterproductive idiosyncrasy?