Tuesday, December 11, 2007

It's fun being a contrarian but they lose money

LONDON (Reuters) - It's fun being a contrarian but it's damn hard to make money at it.

Those who called the end of the credit and housing bubble while most were still applauding "good business" can pat themselves on the back -- but usually a pat is the most, or best, they can expect.

That's because "momentum" trades, buying what is rising and selling what is falling, tend to take on a life of their own, driven by the human tendency to stick with what works and back what is popular.

Jonathan Stubbs, European equity strategist at Citi, has gone to the trouble of tracking the performance of portfolios of "contrarian" investments, those which have done poorly, against those that have done well, so-called "momentum" picks.

Even in 2007, with its sea changes in financial markets, a portfolio of the bottom ten 2006 performing stocks in the DJ Stoxx Large Cap European index underperformed winners the following year by 26 percentage points. That makes the fourth straight year - and the ninth of the past 12 - that contrarian picks underperformed.

For FTSE 100 stocks, momentum buys outperformed in 16 of the past 23 years.

"The contrarian call works very well, often recovering all of the underperformance, only rarely," Stubbs wrote in a note to clients.

"It works at turning points."

And turning points are relatively rare, and can lag changing fundamentals, which should prompt such inflexion points, by years.


"As long as the music is playing, you've got to get up and dance. We're still dancing," former Citigroup Chief Executive Charles Prince said in July, in a much derided comment.

But truthfully, though we can all now "agree" that leveraged buyout lending was a bubble in retrospect, an emperor who admits he has no clothes rarely wins praise from stockholders and boards.

And indeed while Prince lost his job when the music stopped, he would almost certainly have lost it one or two years earlier if he had withdrawn Citi from the lending that now seems unwise.

It might have been better if he had, but the pressure to go along with the crowd is intense.

Take also for example Tony Dye, the admirable former Phillips & Drew fund manager, who correctly called a U.S. and internet stock bubble through much of the late 1990s, prompting huge underperformance for his clients while prices rose.

Sadly, patience ran out for Dye, who had been perhaps the most powerful fund manager in Britain, in March of 2000, and he and Phillips & Drew parted company just as U.S. and internet stocks began a well-deserved but belated multi-year fall.

And while Dye, and many others, were right in their analysis about dotcom stocks, they ignored the enormous importance of crowd behavior.

It can seem insane when masses of people buy Miami condos at impossibly high prices, or lend money to private equity shops at correspondingly low rates.

But the crowd has powerful things going for it. Firstly, the group has more information in aggregate than any individual. It's not always right, but it is telling you something important.

And secondly, and more powerfully, the crowd has a strong tendency to reinforce its own behavior. Prices going up bring more buyers, in investments if not in onions, which often forces prices higher still.

It is simply not enough to be right when most others are wrong: you need a catalyst to change enough other people's minds. This year it was a rash of defaults on U.S. mortgages.


So, if being a contrarian is loser's game, where is the investment momentum heading in 2008?

Emerging markets and natural resources would be easy picks, or just about any currency against the dollar.

It is also easy to see where momentum has stalled.

Stubbs at Citibank points out that 2007's underperformers have a common theme: leverage.

We are coming out of a huge borrowing and real estate binge, a fact dismissed a year ago but conventional wisdom now. It will take time, a lot of it, for banks to rebuild their lending capacity and for real estate prices to reset to sustainable levels.

Be they banks or housebuilders, or even retailers dependent on over-leveraged consumers, it is hard seeing a quick turnaround in companies whose fortunes depend on the easy and cheap availability of credit.

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