Contrarian thinking & Momentum investing

At a diner lately, a friend of mine asked me what I thought of the stock market. I am always embarrassed to share my views on the topic. After all, no one knows everything and everything changes. Yet,  I mentioned that I was somewhat concerned by bubble like patterns in growth/momentum stocks and, that markets were all about money flows, about finding the right balance between income and capital growth and that the price of most assets looked high with not many places to hide and that therefore with the return of inflation and credit risk, a sizeable correction if not a bear market (we haven’t had one for the last ten years) could be around the corner.  This friend replied with a joke that over the last ten years, I must have called seven of the last two market corrections.

He was right of course, but only partly. What most fail to understand is that I do not predict, I prepare. I look at the world through a four dimensional probabilistic dynamic matrix that tells me whether the odds are truly in my favour, whether I have an information edge, a margin of safety and enough conviction to bet with the right size (for it’s not how often I am right that counts, how much money I make when I am right and how much money I lose when I am wrong). I believe luck plays a role in investing but that luck is preparation meeting opportunity.

Change is the central piece of this investment philosophy. It makes me a contrarian investor almost by default. Being contrarian means I am always on the look out for catalysts for change, looking at the opposite side of the trade and the trend and check if the trend and what future the majority is pricing in makes sense.

This does not mean I cannot enjoy the comfort/joy of being on the right side of a big trend and let the trend following do all the heavy lifting. But being agoraphobic and paranoid, I always feel uncomfortable when the masses are at the steering wheel and when too many people make money too easily.

Therefore, by nature and by training, I never assume anything and never follow the crowd. I am always preparing for the worst. I strongly believe that great investing is about taking care of the risks and possible losses and let the profits take care of themselves.

Common sense is not so common noticed Voltaire. So just by keeping it simple and focusing on reliable catalysts, an investor can obtain an important edge. However, the best investors are not just using common sense, but uncommon sense and avoiding all non sense be it common or uncommon.

My greatest strength and weakness have been to set part of the crowd too early and not use the power of momentum and trend following to the full. I had to learn to enjoy the power of momentum, instead of fighting it, but still always ask myself if the trend makes sense, if the trend reflects the wisdom of the crowd or the madness of the masses. In brief, I think contrarian, but act with the trend with a view to fully leverage the power of momentum.

Successful investing consists in using the market and not be used by it. You have to do what is right for you, which is not necessarily what is right for the others. This means that there are times when it’s right to be contrarian (buy low to sell high), but that there are also times, when it pays to use the power of the crowd, the herd mentality and when it’s right to buy high and sell higher.

Herd think

„In theory there is no difference between theory and practice. In practice, there is.“

This quote from Yogi Berra could have been given by Kahneman and Tversky when their experiments revealed that the so-called "homo economicus" was a pure invention from university math professors and did not reflect the rather more complex and multifaceted reality of human behaviours.

If greed and fear are the primeval instincts at the heart of market actions, herd instinct is probably a close second. We are social animals. It it is in our nature to herd. Our ancestors were called apes for a good reason: they ape, they imitate. 

If you were able to ask a zebra or an investor (and all gregarious species for that matter) why they herd, why they follow their mates blindly and react in synch with their peers, they will probably tell you that it stems from survival instinct. It is the most comfortable choice, make them feel stronger. In their experience, it’s generally the first zebra who ventures to new water spots or grass, that serves as lunch to the lions. Better be safe than sorry they say. If everybody does it, it cannot be that bad.

While the lions are busy eating a few of their mates, the rest of the pack can peacefully mow and drink, chatting about how good life is being part of the herd with other look-alike zebras who agree all the times. They never talk about their former neighbours being eaten alive by lions, in part because it did not happen to them and can be seen as a statistic in the bigger scheme of things, a classic survival case of collective rationalisation.

I know what you might think. On an individual basis, you would rather be a lion than a zebra. But as as a species, zebras do far better than the lions. You can spend hours looking for a lion in the savanna, while zebras and other herds are everywhere. 

The so-called „institutional imperative“ is not so different. Portfolio managers are also driven by similar survival instincts. They too herd. After all, winning unconventionally could be seen as either a fluke, an accident waiting to happen, in brief „too risky“, while losing conventionally is seen as „normal“  and lower risk in the purest mathematical sense. Beta may also may happen to mean averagely stupid in French, but in stock market term it is supposed to be efficient. As a result, the market is almost by nature a trend follower, a herd where people prefer to buy stocks whose prices are hitting new highs and sell prices that are going down and where benchmarking rules.

And here lies one of the key paradoxes of the stock market. While this herd mentality may feel collectively rationale, it does not make sense economically. In a rationale world, falling prices at constant supply should drive demand higher. When I see a nice suit that I want to buy, I wait for the Sale to buy it at half price. When a supermarkets sell 3 items that I would buy every week for the price of 2, I take advantage of the discount. In the financial markets, if you buy something and it falls soon after after, you start wondering. Is that a mistake? Why are the rest of the market not seeing what I see? Do they know something I don’t? You want others to agree with you if not today, at least soon enough. If you buy something and it goes up, you feel vindicated in your choice and feel good, while you should rationally hope for the price to fall further to buy more of the good stuff.

In a herd, when prices fall, it signals danger, losses and the tendency is to sell losers and buy winners. The benchmarks themselves are naturally rebalancing themselves towards the winning stocks, which eventually take the lion’s share of the index. As the name of the game is to outperform or more exactly not under-perform too much the index, the „active“ investor tend is rationally enticed to herd and the behave irrationally.

Once I wanted to see an independent movie. It was summer time. I arrived early. I took my seat. After a few minutes, I started to wonder. Why am I alone? Is the movie showing at all? Is this the right place? Is the film so bad that nobody wants to see it? Doubts creeped in. In classic herd think, I felt compelled to leave the room to check that it was actually playing. Blame my amygdala. We were a handful in the room at the end and the film happened to be not so bad. The lesson sticked with me: it effectively paid off to be thinking independently. I was right, not because the others, the crowd, agreed or disagreed with me, but because the facts confirmed my intuition and thoughts.

In the markets, the same is true, but only to an extent. While it is important to think about fundamentals to assess the long term value of an asset, the price of that asset may fluctuate widely around that „fair value“ based on others‘ opinions and expectations. As Buffet puts it: in the long run it is a weighing machine, but in the short term, markets are a voting machine or like Keynes said a beauty contest, where the game does not consist in picking who you think the most beautiful girl is, but who you think the rest of the jury and the crowd will pick. It does mean you have to agree either. Beauty is in the eyes of the beholder and the fact that the jury does not see how beautiful the other girls are give you a shot at getting them for yourself.

Think different

“If you buy the same securities as other people, you will have the same results as other people. It is impossible to produce a superior performance unless you do something different from the majority.” 

Therefore, superior returns are achieved by being contrarian. This is the key dilemma for active investors, as the market is almost by definition a trend follower.You have to cultivate your difference and at the same time use the power of the crowd to maximise your gains. There are times to be contrarian and times to act with the crowd.

Over the years, I made decent money as an investor. Mostly by being early. Being an independent thinker means that I have a tendency to be early, sometime three to six months too early. As Rothschild said, „you will never go bankrupt by taking a profit early“. This is true. But you will never get very rich either. The big money I made was “in the sitting”, just holding on to great ideas.  Being contrarian saved me at the peak of the internet bubble and led to me to cash in just before the beginning of the great recession, or buy stocks a few months after the Lehman debacle. But, it also led me to sell great ideas far too early.

„Be greedy when others are fearful and fearful when others are greedy“ is a great strategy, but if and only if you’re ready to hold on to your positions and use the crowd to your advantage or if you do not have to sell and can hold on forever (like Buffet).

Use the trend as a friend

Greed is infinite and fear finite, while irrational behaviours have a tendency to last longer than short sellers can stay solvent, which tends to self fulfil itself. As the herd are reinforced in their conviction than buying the darlings of the time is a winning strategy, they will continue. This is in essence why stocks have a tendency to trend and why therefore trend following and momentum investing are good strategies.

They follow what can be referred to as Newton first law of motion. An object will stay at rest and in motion at the same speed/direction unless acted upon by an unbalanced force.

Even a game of pure randomness like a game of scissor, stone and paper (which you could just as well replace by buy, hold, sell), Shannon, the man behind Information Theory, demonstrated that there are winning series. It comes that the winning strategy consists in starting randomly, until you win. Then, repeat your winning hand until you lose, at which point return to a random mode. This strategy matches the behaviour of the market and pretty much every evolutionary processes. If there is a trend, stick to it. When it ends and changes occurs, random patterns work well in these range bound/trend-less market, at least until a new trend emerges. Trends exists and in a sense are how order can emerge from chaos. For the uninformed investor, trend following is the most intuitive and successful strategy there is.

For the trend followers, therefore, the trend is your friend. Until the trend changes or is turning, it is often more rewarding to hang in there or even build up position as stocks retreat back for a breather. The trend in a stock price gives you the prevailing bias. If the fundamental case supports it, stick to it.

Use the power of momentum

Remember our E=MC2 post and how fundamental changes and perception changes can reinforce each other.

Momentum investing focuses on these self reinforcing cycles that fuel trends. It looks to benefit from when both fundamental and perception catalysts are turning positive at the same time, when both fundamental value investors can see improving earnings and value, while momentum investors can witness accelerating/improving earnings revisions and price moves. This sweet spot of the S curve is when both value and momentum investors are buying. This pattern of acceleration is relatively well established and does happen when perception changes on the back improving fundamentals and does generally goes well beyond that point, as the trend won’t stop until a new fundamental piece of information derails it.

Jim O’Neil, founder of Investors Business Daily, and best selling author is the pope of momentum investing. Its CAN SLIM methodology which focuses on simple momentum metrics such as Current EPS, Annual EPS increase, New Products/New Management/New Price Highs, Supply & Demand (volume of trading), Leaders and Laggards (stick to the winners), Institutional Sponsorship and Market Direction (money flows).

In physics, momentum defines the quantity of motion of a moving object, which itself is a function of the force/mass at work and speed/velocity of the impetus. In markets, it relates to scale of the change and information gap that such change creates and the speed this information get filled. It relates to the mass adoption of an idea. As such momentum must be looked at as a chain reaction and contagion of belief,  of reinforcing biases and anxiety.

In financial markets, it is the difference between fundamental momentum and perception/price momentum. Fundamental momentum is growing mass, what Simon Sinnek describes as the law of innovation diffusion. Perception/price momentum is like growing velocity of that diffusion. It reflects more buyers chasing rising prices and less deniers, sellers/short sellers. Of course, like all good things, too much velocity is dangerous. When momentum is only about price momentum, then crashes happen.

Great value stories are generally short selling positions about to be covered. Value investors would tend to look at the value of the assets throughout the cycle, while the short selling pressures would mostly react to the price trend. Contrarian investors would start buying after falling prices. Momentum short sellers would cover their position because prices stop falling, thereby adding buying pressures. Fundamental and perception would improve soon after, thereby adding buying pressure, up to the point when the only thing carrying the story is a rising a share price and momentum buying, at which point contrarian value investors would have sold and contrarian value short sellers would start contemplating their next move.

Of course, human nature has its ways of skewing the pendulum in an irrational way. But fortunately, gravity (interest rates and value) still rules. When too many zebras eat the same grass and drink the same water, there is trouble around the corner. They will soon drink all the water and look for new pastures, where lions will be waiting patiently more often than not in the shadows of the trees...

Keep an open mind

If you want to win what can be seen as a losers‘ game, you must be a leader and never follow the crowd. Instead, you must learn to think independently and learn about crowd psychology for the crowd has to adopt your views and follow your lead for you to make money.

Independent thinking is key to avoid being lured by the sirens of the market, but also to use the power of the crowd and avoid the madness of masses. But it requires an open mind. History is littered with contrarian investors that have stayed on the other side of the crowd only to be ran over by a thundering herd of bulls. When investing, one need to put one’s ego in check.

As a result, convictions can be more dangerous enemies of truth than lies. Having conviction and keeping an open mind, requires a certain detachment, but also understanding of others. Ego is the enemy. It is never about you or which stock you think is going to outperform that matters, but how the crowd sees it. In that regard, think of yourself more like a shopkeeper. What you own as inventory is what you want to sell later at a premium to what you paid for. That way, you can think of your portfolio as a mix of staples that the crowd will always need to buy and some fashionable widgets they might want to buy for the next season.

No one knows everything and everything changes. The way of the Tao is reversal. 

„If you have a problem, inverse always inverse“ said Einstein. Therefore, when the crowd starts overshooting on greed or fear, take a contrarian view. This is especially relevant when the market becomes one-sided and enamoured with a specific sector or stock or when analysts talk about new paradigms (“this time is different”) or conversely when the market can’t seem to see any light at the end of a long bear market. Contrarian pays at the extreme. When the crowd start moving to your contrarian way, stick to the trend. As a result, start contrarian (our first buy after a big sell off), follow the trend (our second sizing up the position buy), and switch back to contrarian mode (we hold) and back to momentum (sell).

The shortest poems I ever heard is from boxer legend Mohamed Ali but summarises the value of this back and forth Tao of value investing: „Me, We“.

Buffet puts it: „a good player plays where the puck is, a great player plays where the puck is going to be.„ So if you want to be great, think contrarian first and act with the trend second.

	Momentum Bull	Momentum bear
Contrarian bull	STRONG BUY (valumentum Sweet spot)	BUY (value)
Contrarian bear	HOLD	SELL

	Sell side bear	Sell side bull
Buy side bear	BUY	HOLD
Buy side bull	BUY	SELL