Investment: Contrarian investing – Bucking the trend does not always pay off

Annual Contrarian Stock Perfomance

Juergen Buettner

Acting counter-cyclically as an investor sounds like a plausible investment strategy, but successfully implementing such an approach has to be learned.

Only a few investors permanently succeed in their attempt to beat the stock market. This sobering result can be partly explained by the nature of human beings to act as herd animals. According to a study at the University of Leeds, for example, a minority of 5 percent is enough to determine a direction, which the rest of the group then follows instinctively.

This drive can be a hindrance when investing in stocks. Experience tells us, at least, that the majority is not always right on the stock market. Instead, the typical course of a market cycle was once described completely correctly by Sir John Templeton, founder of mutual fund company Templeton: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria.”

There are numerous practical examples to support this thesis.

The dream of spectacular investment success

The massive Nasdaq bull market, for instance, made way for a sharp slump in stock prices at a time when most investors were looking through rose-colored glasses, believing that the future for stocks would come from the booming sectors of technology, media and telecom. In contrast, in 2009 in the middle of the credit and EU crises, the ground was laid for one of the most impressive bull markets of all time.

Formative experiences like these explain why some investors swear by a counter-cyclical approach as an investment strategy – particularly as they assume that they can base their belief not only on John Templeton, but also on other investment gurus. After all, it was no less than Warren Buffett, considered by many to be one of the greatest investors of all time, who once advised: “Be fearful when others are greedy and greedy when others are fearful.”

However, the popularity of so-called contrarian strategies not only has to do with such plausible sounding quotes, but also with another characteristic of humans: narcissism, and the fact that with successful bets against the broad market, the ego is strengthened considerably. On top of that, it often pays huge, when contrarians are right. Contrarian bets in the year 2000, for example, delivered gains of more than 80 percent, and in 2009, gains of more than 50 percent.

This sounds great, but it does not tell the whole story.

Recently, contrarians learn the hard way

The reality is reflected in a Citigroup study, in which analysts used 1998 as a starting point and compared the annual performance of the contrarian approach to the momentum approach. According to the study, contrarian strategies made money only in six out of 17 years. Last year the approach did not work out at all, and in 2014 and 2013 it even resulted in heavy losses for the contrarians.Based on these results, Citigroup strategist Robert Buckland takes some wind out of the sails of those investors, who swear by counter-cyclical investment strategies.

“Overall, we remain suspicious of simplistic contrarian strategies,” he says. But at the same time he acknowledges that “simple contrarian strategies can perform spectacularly well at big macro turning points.”

Commodities, emerging markets attract counter-cyclical investors

Hard-core countercyclical investors are hoping that 2016 will be one of these spectacular contrarian years, especially since recently, for the first time, there were three years of losses in a row since Citigroup started to study the success of contrarian investment approaches. Therefore, the time for a comeback seems to be overripe from the perspective of a contrarian. At the turn of the year there was no shortage of clear candidates to implement such a strategy. Those who wanted to swim against the current on the buying side were betting on stocks from emerging markets and the commodity sector. After long-lasting sell-offs in both cases, these segments of the markets fell completely out of fashion.

However, bets on falling stock prices, on the other hand, seemed to be a good choice for the discretionary consumer sector. The reasons for that choice were not only the stocks’ relatively high valuations, but also the fact that this sector had the highest overweight position in the monthly BofA Merrill Lynch survey. Also, the exposure in stocks from the eurozone was, and is, comparatively strong, which according to counter-cyclical investment rules can be seen as a warning sign.

A blind contrarian approach seems to make little sense

Now that the early months of the year have passed, it looks as if contrarian bets are working again. Commodity stocks, especially from the gold sector, are suddenly in demand, whereas most stock markets in the eurozone are having a very hard time. What will happen during the rest of the year remains to be seen, but because of the prevailing volatility, correct contrarian bets promise huge profits and failed bets pose big losses.

Recent developments may also induce many contrarians to bet on the overall market. The often badly depressed short-term sentiment indicators lure counter-cyclical bets on rising prices, but this investment idea is a reminder of another fundamental problem of this approach. Contrarian indicators often send different signals. Thus, the continued willingness of many investors to take any price dip as a buying opportunity can also be understood now as a signal for continuing widespread optimism.

Whether investment strategies based on counter-cyclical principles will finally work out in 2016 will also depend on whether there a big macro turning point emerges. Anyone searching for the right investment approach should think about the meaning of another quote from Warren Buffett: “None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy.”

Following this suggestion, it seems advisable to act only sporadically as a contrarian in cases when this approach is not only supported by sentiment indicators, but also by valuation considerations and corresponding chart signals. At least one thing seems to be clear: Stubborn loner-thinking is not successful in applying contrarian strategies. Rather, it is very important to find the right starting time to swim against the current. Otherwise contrarian investing can become quite costly.