Time to Be a Contrarian

Friday, June 4, 2010

Investor and media sentiment has coalesced around a key thought: The economy is about to slow, stagnate and/or turn down – therefore, this is not a time to buy stocks. Whenever widespread agreement occurs in investing, invariably the smart action is contrary to common belief.

Here’s what investors are doing and examples of how they are misinterpreting the trends.

Note: Contrarian investing can be a challenging concept. If you would like to read more about how and why it works, see “Investment Insights – Contrarian Investing”).

Mutual fund flows can be a valuable contrarian indicator

As discussed previously, investors, after heavily liquidating mutual fund positions in late 2008/early 2009, moved back into bonds, but not stocks. There was some buying of foreign stock funds, but virtually none of US stock funds for many months, even as the US stock market rose appreciably. This March-April period saw a beginning return to US stocks, but that movement was cut short by Greece contagion, the May 6 stock market shakeup and other negative news. In May, sales of US stock funds were large.

Professional investment managers often watch mutual fund flows as a contrarian indicator. The reasoning is that many mutual fund investors buy and sell based on past performance and how they feel about investing (in other words, buy high, sell low). Thus, large purchases can be a danger signal and large sales, an opportunity sign. The latter is where I believe we are today.

Misreading economic indicators

When people get worried, it is easy to see every half-full glass as half-empty. The media, too, following this general sentiment, focus on the negative. Here are some examples:

  1. Housing – “Stimulus ended in April, so sales will now decline.” There are two problems with that conclusion. First, auto sales continue to increase even though that stimulus ended last year (amid predictions of a subsequent sales slump). Second, analysts and the media now use raw (not seasonally adjusted) house sale data. Therefore, this summer we could see reports of large sales increases simply because the dampening seasonal adjustement will be missing. (For more information, see “The Wall Street Journal Gets House Price Trend Wrong – Interprets Case-Shiller Data Incorrectly” – April 29.)
  2. Employment – “Sure hiring is up, but the unemployment rate rose.” Yes, and that’s a sign that people who had given up before have regained the confidence to reenter the workforce. Importantly, this is a common occurrence as the economy improves. Therefore, instead of one positive and one negative, we actually have two positives.
  3. One-sided analysis – “Euro falls, oh my!” I covered this before, but it bears repeating. Many economic/financial items are two-sided. A perfect example is exchange rates. If the Euro falls, the US dollar rises. Clearly, that situation is not all negative – or all positive. It is simply a change that produces effects, from accounting adjustments to business and investment risks and opportunities.

So… Take today’s widespread negativity as support for having a positive outlook. When others put on rose-colored glasses, then we will worry.

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John Tobey on Seeking Alpha

Seeking Alpha Certified

June 2010