The Art of Contrarian Investing is the Art of Taking the ‘House View’

In the consumer goods industries, it is clear that consumers want to acquire consumption goods and that producers want to acquire monetary profits. In this way, both parties gain from each other and their preferences are broadly inline. In stark contrast, the business of financial speculation displays more antagonistic characteristics. When two financial speculators execute a trade against one another, there is no clear ‘producer’ or ‘consumer’, rather, both of them want the same thing (a profit) and yet only one of them can have it.

 

In my mind, the age-old method of contrarian investing is a means of navigating the antagonistic waters of the financial markets. Here, I explore the principles of contrarian investing in the rudimentary supply/demand framework.

 

Execution Decisions in Consumer Goods Industries Vs Execution Decisions in Financial Markets:

 

In the consumer goods industries, the decision to supply or demand a good are based on solid ground. For the producer, the decision is based on economic calculation (expected sales revenue – input costs), and for the consumer, the decision is based on perceived personal utility (whether they personally prefer the good to the money). In this way, the demand and supply curves remain relatively stable and can be depicted in the usual fashion:

 

Supply Demand Graph

Source: typepad.com

 

In the industry of financial speculation, there is no clear ‘producer’ or ‘consumer’ (so to speak). Moreover, the attempt is to gauge the future preferences of buyers and sellers of the financial asset. The lack of a universal objective method (economic calculation) or even an internal measure (perceived personal utility) creates an environment where suppliers and demanders of a financial asset are operating in a market that doesn’t display the usual economic correlations:

 

 

Conflict in Financial Markets:

 

In the financial markets, there is no clear-cut consumer or producer. That is to say, the person who makes money from – say  - the stock market is neither forever long nor forever short. So, since the side that makes money isn’t forever fixed, the arena is such that people are constantly jumping from the supply-side to the demand-side (and vice versa). It is often said that this scenario is similar to a poker game. After all, in a poker game, there is no clear-cut ‘producer’ (as with other casino-based games), and hence it is possible to exclusively play when the odds are in your favor. Likewise, I contend that – in the realm of financial speculation – it is possible to execute only when the odds are in your favor.

 

The Contrarian Principle:

 

The contrarian principle is profound but simple: – when the majority of people are looking at prices in one particular way, it is desirable to look at them in precisely the opposite way.  The reasons behind this principle are perhaps more complicated. If most people are thinking that prices should behave in a certain way (i.e. go up or down), then it is likely that they are aligned in the supply/demand framework to match that conviction. Given that they are essentially trying to gauge the future supply/demand conditions for a certain asset, we can see why they are likely to fail. They cannot escape the ‘lens with which they view reality’, and they cannot escape the fact that such lenses are the product of their past experiences and prejudices. So, when people – en masse – become convinced about the way in which prices should move, they are making a guess about something that they cannot possibly know – the perceptions, preferences and belief structures of others.

 

So, if people are convinced about something they cannot know in a collective fashion, then there must be limited potential for them to be right and enormous potential for them to be wrong. That is, the optionality in opposing their trades will be great (with a limited downside). If only a small proportion of a consensus changes its mind, then the effect on the supply/demand situation could be great. However, if the consensus happens to be right, the effect would probably be limited.

 

This is the great risk/reward scenario that comes along with contrarian investing.

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Posted May 17, 2011