Friday, January 8, 2016

A Contrarian Investment Strategy for Any Market

The Holy Grail of investment management is to try to create an investment strategy that can generate returns in any market environment.  Markets either move up, down, or sideways.  It is not hard to devise a method to profit in one of those environments, being able to profit in all three is quite difficult.  This post will present a contrarian investment strategy that can do just that because it doesn't depend on the overall direction of the market, instead it focuses on the predictable emotional responses of human beings who trade in the markets.

Traditional Approaches

The traditional investment approaches all have significant flaws:

1. Buy and hold an S&P 500 Index Fund---In this approach you would just buy a fund that tracks the market (S&P 500) and hold onto it forever.  You would ride the market up and you would ride the market down.  The obvious flaw here is the ride the market down part.  You would have some great gains in a bull market and give them all back, and possibly then some, in a bear market.  All along the way this approach would also be very volatile so you would have to endure a wild ride as you move up and down with the market swings.

2. Asset Allocation/Modern Portfolio Theory--In this approach you would hold a diversified portfolio of assets.  You would have large stocks, small stocks, value, growth, international, and some bonds.  This would probably offer an improvement in volatility over holding an index fund and it could do a little better in a bear market. However, investors would still be subject to large losses as assets that may not be perfectly correlated when markets are rising become correlated when they are falling and there is panic selling. 

3. 60/40 Portfolio---In this approach you would have a static allocation to 60% stocks and 40% bonds.  The idea is that the bonds would provide protection against a market decline.  The problem is that the stocks will have much larger moves than the bonds, so in a bear market the bonds may increase in value but not enough to protect against large losses.  Furthermore, in strong bull markets the bonds will reduce returns.

4. Market Timing--A market timer tries to predict what direction the market is going to go in and position accordingly.  While this sounds good in theory, in practice nobody can accurately predict the market.   You might get lucky sometimes but over the long term this is not a winning investment strategy.

5. Traditional Tactical Asset Allocation--This approach seeks to be in harmony with market trends.  When markets go up you are in stocks and when they start to go down you get out of stocks. Unlike the market timer, the tactical investors isn't trying to predict the market they are reacting to it.  This approach is the closest to being able to work in all markets, it can work well when  markets go up and when markets go down, but it will tend to struggle in sideways markets as there is no real trend to hitch onto. 

None of these approaches work because markets are not random or efficient.  They are not random or efficient because human beings are making the trading decisions that move markets.  Human beings have emotions and there is no way to avoid having their emotions influence their trading decisions.  The two strongest emotions that dictate where stocks will go on a day to day basis are fear and greed. 

When the market is rising greed kicks in.   Maybe some good news came out and the market starts to go up.  Investors see this and get optimistic and start to buy and buy some more.  Then greed kicks in and investors move markets up to a level where people start to worry that prices have moved too far too fast.  Investors who bought also want to take their profits as they start to worry that their profits on paper might disappear.  Fear is starting to kick in.  This causes markets to move back down to some sort of equilibrium that balances out buyers and sellers.  The same process works on the downside.  Maybe some bad news comes out and now the market is declining.  Fear is a more powerful emotion than greed and investors start to sell indiscriminately as they are afraid that the markets will crumble and they will lose a lot of money.  Markets decline to a point where bargain hunters come in, greed is now starting to kick back in.  The bargain buying moves the market back up to some sort of equilibrium.

Greed and fear in the market cause the market to reach levels knows as overbought (moved up too far too fast and due for a retracement) and oversold (moved down to far too fast and due for a retracement).  Regardless of the overall longer term direction of the market these cycles play out on a daily basis with the market moving from equilibrium to overbought, back to equilibrium, to oversold, etc. 

Buy Low, Sell High

We have all heard the adage "Buy Low and Sell High".  It makes perfect sense, if you want to make money consistently then buy a security for a low price and sell it for a higher price, but investors don't do it.  Most investors believe that the most recent past equals the future.  When the market is going up they believe it will continue up and when it is going down they believe it will continue down.  This causes them to buy into rallies and sell into downturns, buying high and selling low.  Because of investors emotions causing the market to move between overbought and oversold, this is the exact opposite of what they should be doing.  A contrarian strategy would be to buy when markets are oversold, buying low, and sell when markets are overbought, selling high.

This is easier said then done.  To make this strategy work you need to be buying when most people are selling and when the talking heads in the media are spreading doom and gloom.  Then you need to sell when most people are buying and the media is telling everyone how wonderful things are.  Going against the herd is not easy, but it is profitable.  Study after study shows that the average investor doesn't make money in the market.  If you want to do well then  you can't do what the average investor does, you have to do the opposite of what they do.

There are a couple of steps necessary to make this approach work:

1. It needs to be quantitative---If you try to be a contrarian without a quantitative approach then your emotions will betray you.  You need to create a system and stick to the system.  A well thought out contrarian approach will be profitable most of the time if you stick to it.

2. You need to have multiple ways to measure if a market is overbought or oversold----There is no one measure that can tell you when a market is overbought or oversold.  There are a number of methods that work very well---RSI, cyclical analysis, intermarket analysis, etc---but they don't work all of the time.  Instead of trying to find the one approach that works best, you should blend multiple approaches.

3. While the overall direction of the market doesn't matter for this strategy you still need to treat uptrending markets differently than downtrending markets.  In a bull market greed is the dominant emotion.   From time to time it gets replaced by fear but it will quickly come back.  So in a bull market, buying the dips is almost a license to print money.  In a bear market fear is the dominant emotion.  It sill makes sense to buy the dips but every once in a while you will buy a dip that keeps on dipping longer than usual.  So, while in a bull market you might want to use leverage to boost returns, in a bear market you may want to keep large amounts of cash and/or Treasuries as a hedge and only buy the dips with part of the portfolio.

This contrarian strategy can work well in any  market environment---up, down, or sideways---because it doesn't rely on the long term direction to make money.  Instead, it relies on investors having predictable emotional responses to the daily moves of the market.

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