Contrarian Investing … Swimming Upstream by Brad Skiles, CLU®, Chfc®, CFP®, CLTC Number 13
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ECON 101 CENTER STREET PARTNERS Presents: Contrarian Investing … swimming upstream By Brad Skiles, CLU®, ChFC®, CFP®, CLTC Number 13 Perhaps the most common investment principle is: “Buy low, sell high.” Most long-term investors who have made money, have experienced this axiom (generally, you can’t make money unless the current price is higher than the original purchase).1 As simple as it sounds, many people don’t understand this principle. Let’s dig deeper. Buying Low Doesn’t Feel Good If an investment is “low,” that generally means there are more sellers than buyers. Markets are based on supply and demand. An over-supply and a weak-demand, result in a lower price. But why are there more sellers? “Fear” is the emotion often used to describe market bottoms. The fear that more money could be lost on this investment, drives people to liquidate the investment. Like screaming “fire” in a theater (don’t do it!), mass psychology takes place. In the investment community, this is called, “capitulation.” Investopedia.com defines capitulation as: “When investors give up any previous gains in stock price by selling equities in an effort to get out of the market and into less risky investments. True capitulation involves extremely high volume and sharp declines. It usually is indicated by panic selling.”2 It shouldn’t be too difficult to remember the emotions connected to the market bottom of March 6, 2009. The Dow Jones Industrial Index3 touched 6,443, a 54% decline from its October 2007 high.4 A lot of uncertainty existed. Many investors were discouraged with the housing market, the banking system, and the government. When it came to the market, more people were selling than buying. When the masses have thrown in the towel and given up on a market, it is “thought that there are great bargains to be had. The belief is that everyone who wants to get out of a stock, for any reason (including forced selling due to margin calls), has sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that the true capitulation is the sign of a bottom.”5 In any market, for every seller there is a buyer. So, not everyone has given up. Eventually, the price falls to a value where new buyers are attracted. It may be counterintuitive, since the masses are selling, but enough buyers enter the market to stabilize the price. The buyers are hopeful they got a good deal. It is a step of faith. Buyers hope for a price recovery. 1 Examples of Swimming Upstream If buying low is scary, then buying high is often exciting or at least comfortable. Few people challenge the decision to invest. This is the consensus view … everyone seems to believe the market will go higher. The contrarian, however, goes “against the flow.” For each of the following declarations of optimism, there were voices expressing concerns. In September of 1929, less than two months before the stock market crash, Irving Fisher, one of the most recognizable economists of that time, said: “There may be a recession in stock prices, but not anything in the nature of a crash. Dividend returns on stocks are moving higher.” A month later, he “declared that stocks had reached a ‘permanently high plateau,’ and did ‘not feel that there will soon, if ever, be a fifty- or sixty-point break below present levels.’”6 The Austrian economist Ludwig von Mises, however, in 1928 “understood that the inflationary boom was inherently unsustainable and had come to an end. The permanent prosperity that mainstream economists spoke of was a fantasy, a fraud. ‘It is clear,’ said Mises, ‘that the crisis must come sooner or later. It is also clear that the crisis must always be caused, primarily and directly, by the change in the conduct of the banks. If we speak of error on the part of the banks, however, we must point to the wrong they do in encouraging the upswing. The fault lies, not with the policy of raising the interest rate, but only with the fact that it was raised too late.’”7 Four days before the Nasdaq peaked in March of 2000, former Federal Reserve Chairman Alan Greenspan said in a speech at Boston College: “The fact that the capital spending boom is still growing strong indicates that businesses continue to find a wide array of potential high-rate-of-return, productivity- enhancing investments. And I see nothing to suggest that these opportunities will peter out any time soon. Indeed, many argue that the pace of innovation will continue to quicken in the next few years, as companies exploit the still largely untapped potential for e-commerce …”8 On the other hand, on January 3, 2000, hedge fund manager Bill Fleckenstein wrote, “As liquidity was jammed in all year (1999), it had to go somewhere and it went to places where there were the fewest fundamentals, and the most imagination—that is, Internet stocks. That’s the way speculation often works; it seeks ideas with the highest imagination potential and fewest hard facts. Greenspan fueled all sorts of Internet ideas no matter how risky or kooky … The price of Internet stocks went so high, so fast and made some folks so much money, that people concluded … there must be something to the Internet.” In February of 2000, he wrote, “When we look back on this, those are the kinds of big numbers that will cause people to say, ‘How did anyone ever think those things were possible?’”9 In July of 2007, Federal Reserve Chairman Ben Bernanke gave this report: “The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards, and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that, despite the recent increase, remain fairly low relative to historical norms … declines in residential construction will likely continue to weigh on economic growth in coming quarters, although the magnitude of the drag on growth should diminish over time. The global economy continues to be strong, supported by solid economic growth abroad. U.S. exports should expand further in coming quarters. Overall, the U.S. economy seems likely to expand at a moderate pace over the second half of 2007, with growth strengthening a bit in 2008 to a rate close to the economy’s underlying trend.” 10 2 While Chairman Bernanke didn’t anticipate a housing bubble, market commentator James Dines did. On August 24, 2007, he wrote, “The Dines Letter has been predicting a ‘recession in 2007 spearheaded by a real estate crash,’ which is why stocks related to banks, insurance companies and real-estate companies, have been conspicuously absent from our Supervised Lists.”11 What to Do? The point is that in order to sell high we have to buy low. But in buying low, we may be buying when most people are selling and when the fear factor is high. Warren Buffet says, “Be fearful when others are greedy and greedy when others are fearful.”12 An 18th century British Rothschild was credited with saying, “The time to buy is when there’s blood in the streets.”13 Here are some other applications. 1. Consider whether the market is in a bull or bear market cycle. Long term bull markets may be forgiving as they return from a decline to set a new high. Long term bear markets are defined as being unable to sustain the last high. But, even long term bear markets may have short term bull markets, providing investment opportunities. (See my article, Understanding Bulls and Bears,14 archived on my web page, for a further discussion on this topic.) 2. Dollar-cost-averaging may help your recovery. If you have an investment which experiences a significant decline, a purchase at the new lower price may be helpful. For example, if an original purchase at $100 per unit is now trading for $50 per unit, a second investment (equal in size to the first) may result in an average cost of $75 per unit. Assuming this investment recovers from this low and returns to $100 or more, the investor who utilizes this strategy may have a full recovery when the investment reaches $75 per unit. Without dollar-cost-averaging, the investor is waiting for the return to $100. On the other hand, if there is not a price recovery, then the loss may be greater. 3. Rebalancing allocations during a decline may help to buy low. Diversified allocation strategies do not prevent investment declines, nor do they guarantee investment growth. But they may be helpful in reducing declines or preparing an investor to take advantage of lower prices among some asset groups. 4. Evaluate the sources of your investment advice. Just because someone is a contrarian does not mean they are right. Likewise, just because there may be widespread agreement concerning the market doesn’t mean that view is correct. Since humans are the buyers, markets are impacted by emotions. Greed and optimism may help to drive a market higher. Fear and pessimism may contribute to a declining market. Emotional people are selling and buying at the same time. The contrarian, though, may be overriding an emotional response in order to buy … hoping the investment rebounds in a way that makes money. It has been said that stocks are the only thing people don’t want to buy on sale. If you understand the emotional aspect of the markets, gaining knowledge about investing may help you make a better decision when the lows occur.