Monday, September 7, 2009 0 comments ++[ CLICK TO COMMENT ]++

Being a contrarian

In my recent blog entry on gold, an anonymous reader wondered why I didn't just try shorting gold as a contrarian bet. I thought it touched on an important element of contrarian investing so I thought I would address that here. The full suggestion was:

Why not short Gold as a contrarian, it is hard to find an opposing view to it hitting $1000.

Why not short it with a stop at 1005 using a minute part of your portfolio because if it doesnt break $1000 the exit will not be big enough and we could see it at below $600

This might sound like a crackpot theory to some but it is contrarian.

Being a contrarian for the sake of contrarianism is very dangerous and likely doesn't work. In the long run, the market is mostly right. If you went against the market at all turns, you will go bankrupt really quickly.

You can easily see this by looking at this blog. If you followed it for more than an year, you'll note that some of the calls where I went against the market were completely wrong. I didn't invest any money in most of them (they were just preliminary thoughts) but I did lose a fortune in Ambac (which was a bullish bet on housing when the market was forecasting massive real estate losses.)

More recently, I mentioned a few months ago that natural gas looks attractive from a contrarian point of view. The market is mostly bearish on natgas (it has bid up the natgas stocks but not the commodity itself.) Fundamentals don't look so good since marginal cost of natgas production in Russia and places like Qatar is supposedly very low (I don't know for sure) and LNG imports from those regions are more cost-competitive than US-produced gas. But if you went long natgas you would have lost a lot of money by now.

In my opinion, there are two reasons I pursue contrarian strategies (but not all the time.) Firstly, it fits my personality. In real life, as well as in investing, it is not my nature to follow the crowd. I'm basically a very uncool guy and, for better or for worse, that's my essence. So, contrarian opportunities fit my thinking and personality. I'm pretty immune to mainstream influence and I actually like listening to and thinking about dissenting views.

Secondly, and most importantly for most people, the benefit of going contrarian is that the upside tends to be large. Since everyone is on one side of the trade, you will get rewarded a lot more on the opposite side if you are right. Of course, this doesn't mean that you will be right.

One way to think of what I'm saying—it's just my way of looking at things and cannot be proven—is to think of probabilities and pay-offs. Going contrarian generally gives you scenarios with high pay-offs but it doesn't necessarily mean the probabilities are in your favour. Just taking a contrarian position does not change your probability. There are some short-term traders who believe the probability changes—these guys believe in cycles e.g. if everyone is heavily long a security, which shows up as strong RSI or momentum in technical measures, they believe it will necessarily revert—but I'm a longer term investor and don't believe that is true in the medium and long runs.

So the most important goal of a contrarian is not to seek high pay-offs. Those pay-offs are automatically high. Instead, it is the contrarian's job to make sure the probabilities work in his or her favour. Blindly betting against the market doesn't mean the probability is in your favour. But if you do research and are confident that the odds are in your favour, then those are the opportunities to pursue.

On To Gold

Going back to the gold example, I'm not a short-term investor so I wouldn't follow the tactic that is suggested i.e. invest with tight stop-losses. Like most long-term investors, I would be more comfortable betting without any stop-loss and tolerating bigger swings.

Short-term investors can probably get away with tight stop-losses but long-term investors probably can't. I suspect long-term investors will keep bleeding away their portfolio if they tried that strategy. That is, if you are long-term-oriented, you may lose 5% on the stop-loss here; then lose another 5% on another bet; and another 5%; and so on. It is virtually impossible, even for the best, to call prices within a 5% range in the long-run.

So, if it were me, I would bet without a tight stop-loss while considering the long-term outlook. Although I keep saying that stocks are more attractive than gold, I don't believe gold can be considered to be in a bubble unless you are certain of strong deflation. Even with my deflation tilt, I'm only expecting mild deflation (say like Japan) so it's hard to bet heavily against gold.

So, shorting gold doesn't appear to be in one's favour. The time to short gold is if we get a speculative blow-off, like oil last year. I think there is a chance of this happening so one should wait.


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