Wednesday, June 24, 2009
Back on December 1, 2008 I turned long term bearish on bond prices after being a bull for 27 years! (Remember that when bond prices go up interest rates go down, and when bond prices go down interest rates go up). I regard this call as a quintessential example of the contrarian approach to markets that is explained in my book. Here's why.
The first ingredient of any contrarian analysis is historical value investigation. Where is the market relative to previous highs and lows it has seen in previous years? We have to remember that bullish market crowds are associated with overvalued markets - prices have risen too high. And bearish market crowds are associated with undervalued markets - prices have fallen too low. So if you think you see a bullish or bearish crowd developing you have to check your observations against the position of the market relative to its historical extremes. All of this is explained in chapter 6 of my book.
Now take a look at the first chart above this post. It is a weekly chart showing about 30 months of yield information for the 10 year US treasury note. Back in 1946 long term treasury yields dropped to a historical low of about 2.00%. This should be compared with the all time high in the 10 year yield which was 15.96% in September of 1981. So on December 1 of 2008 it was pretty clear that at a yield of about 3.00% the 10 year note was a lot closer to its historically low yield than to its highest yield. Moreover, it had just broken below its previous low yield point of 3.07%, action that was sure to strengthen bullish opinions. For these reasons alone it made sense to be on the look out for a bullish investment crowd in the bond market (bullish in the sense that it expected prices to go up and yields to drop).
There was a second important element in my historical analysis. As I had pointed out in my long term bond market forecast that I had made in 1982 (see the scan in the post I cited earlier) the cycle of falling yields that started in 1981 was expected to last 30 years, plus or minus a few.
By late 2008 this cycle of falling yields was already 27 years old and getting long in the tooth.
These considerations made me certain that a good contrarian trade was at hand - provided a well developed bullish bond market crowd could be identified.
In late November of 2008 people all over the world were fearful of an emerging depression. The S&P 500 had made a temporary low at 740 on November 21. Flight to quality was the preferred investment mode - people dumped stocks and corporate and mortgage bonds and bought government securities. Buying treasury notes was also a deflation play, one that would pay off big time if deflation set in, a typical accompaniment to depression.
So I thought then that the bullish bond market crowd was strong - it was the mirror image of the bearish stock market crowd. And on this basis I thought it made sense to sell out any treasury security postions I held and move those assest back to cash and to the stock market. This I did.
I thought at the time that yields would drop a little more - I cited the 2.50% level in my December 1 post. As you can see from the chart at the top of this post the 10 year yield eventually dropped as low as 2.04% a few weeks later, but has since risen as high as 4.01%. And I think it will go higher still.
Tuesday, June 23, 2009
Chapter 15 of my book is entitled "The Panic of 2008". It documents the enormous, bearish information cascade that progressed through the year. Magazine covers and newspaper headlines documented and amplified investor fears. Eventually a run on the "hidden banking system" developed after the Lehman Brothers bankruptcy on September 15, 2008. Markets around the world crashed and took the world trading system and economy with them.
You can find my real time comments on this information cascade at this link. Every time I imagined the news couldn't get worse, it did. By the end of the year an enormous, bearish investment crowd dominated world stock markets. The vast majority of investors and ordinary citizens shared a very pessimistic outlook for the U.S. and world economy.
I think this bearish investment crowd presents a once-in-a-lifetime opportunity to the contrarian trader. The investment policy for a conservative contrarian is described in my book on pages 129-130. I call it the Contrarian Rebalancing Strategy. At this point in time the conservative contrarian would have a normal allocation of his investment portfolio to the stock
market. In my book I tool the normal portfolio allocations as 60% stocks, 30 % bonds, and 10% cash.
Since a bearish stock market crowd is very much in evidence, the conservative contrarian is now waiting for the 200 day moving average of the S&P 500 to turn upward by 1% from the lowest point is has reached since 2007. As you can see from the chart above (courtesy of StockCharts.com) the 200 day moving average (red line) is still dropping and currently stands at 899. So a 1% advance in this moving average still lies some months ahead of us. When this 1% advance in the moving average occurs I think the conservative contrarian should then put all of his non-cash assets into the stock market.
You may wonder why the conservative contrarian currently has a normal instead of a below-normal allocation to the stock market. I have long maintained that the worse mistake any investor can make is to be underinvested during an extended period of rising stock prices. Such a mistake would cause his investment performance to lag that of the benchmark buy-and-hold strategy. For this reason I think a conservative contrarian should only have a below-normal stock market allocation when there is strong evidence for a bullish stock market crowd. Even then, he should wait for the 200 day moving average of the S&P 500 to drop by 1% before reducing his stock market allocation.
In the present context everything hinges of whether or not a contrarian trader/investor thought there was a bullish stock market crowd dominating the market in 2007. I for one did not and I said so in my book. My media diary did not show any evidence of a bullish information cascade in the stock market. So a conservative contrarian who shared my analysis would have maintained a normal stock market allocation throughout the panic of 2008. (Of course he would have had a substantial reallocation away from bonds and into stocks at the end of the year simply to maintain his 60-30-10 portfolio shares for stocks, bonds, and cash. ) Despite this, he lost no ground to the benchmark buy-and-hold strategy during the panic (cold comfort, I know!).
There were some contrarians who did think a bullish stock market crowd was evident at the 2007 top. If they had followed the moving average strategy described above to reduce their stock market exposure they would have done so on February 20, 2008 at the S&P 1360 level as pointed out in my book on page 190. Right now these contrarians would be sitting with below-normal stock market allocations and would be awaiting a turn upward in the 200 day moving average by 1%. They too would move to an above-normal stock market allocation when this signal occurs.
Friday, June 19, 2009
Saturday, June 13, 2009
My book, The Art of Contrarian Trading, was just published by John Wiley and Sons. You can purchase it from your favorite book store by following this link. It is the definitive book on how to apply the theory of contrary opinion to stock market and other financial markets. It is packed with information about crowd behavior in financial markets, ideas about how to turn the crowd's mistakes into profits, traders' war stories, and lots of ideas that will help you move your investment game to a higher level.
Posted by Carl Futia at 10:54 AM