A Contrarian Prepares for the Unknown

With the summer ending in the next few days, most have turned their attention to end of season parties, final vacations, and preparing to send their children back to school. Although I will be partaking in many of these activities, my thoughts are never far from the market.

The recent rally has stirred investors' hopes, but the next couple of months could bring rain to our parade. Historically, September is the worst month for stocks. Also, many large market crashes have taken place in October. Finally, considering the damage done to portfolios and the economy last fall, I am concerned that unexpected events could trigger wild price swings.

Many of us have been taught that acting in a contrarian fashion leads to large gains. When we're ahead of the crowd, we can acquire stocks at bargain levels and eventually sell them at much higher prices. Although this approach is easy in theory, in practice it's more difficult. Since the markets are highly competitive, with profit-seeking investors all searching for the same ideas, the consensus is often correct. When the consensus is correct, positioning against the crowd does not lead to gains. On those occasions, we are not being smart or savvy, but foolishly taking the wrong side of a losing trade.

For this reason, it is important to gauge sentiment and then determine where the consensus could be incorrect. A comprehensive list of factors that could affect stock prices would be endless. Instead of tackling such a task, I will focus on three key items that have great impact. They are:

•1. Economic Growth - Even the most bullish investors have tepid growth estimates. Many believe any growth that occurs will be short-lived and will drop sharply next year as credit remains tight, consumers deleverage, and savings increase. However, could growth surprise us to the upside? Companies have cut costs to such an extreme that any incremental growth will yield large profits, encourage an inventory rebuilding process, and in turn spark even higher expected growth. Such an event would certainly take stock prices higher.

•2. Volatility Increases - With the Federal Reserve (Fed) pumping liquidity into every section of the economy, many think large imbalances will lead to higher volatility. Since volatility and stock prices are negatively correlated, this occurrence would drag stocks lower and prolong both the bear market and recession. However, the Fed effectively removing stimulus in an efficient manner could produce stability that allows the economy to grow.

•3. Inflation vs. Deflation - This is a never-ending battle between two camps who each expect their side to win. Either the Fed fails and we witness a Japan-style deflationary period, or the large amount of money in the system causes a 1970s-style inflationary spiral that destroys the economy. Both sides have well-documented logical reasons for their expectations. What if they are both correct? Cost-cutting and deleveraging will create deflation in the short-term, but an eventual inventory restocking period and lean corporate cost structures can trigger explosive growth that generates inflation. During such a transition, the nimble will profit as they correctly position for each distinct period.

Unique analysis allows for outsized investment gains. Correctly assessing broad consensus and then creating a different viewpoint will allow you to stay ahead of others. Use the last few days of summer to consider alternatives that will enable you to act quickly over the coming months.

Comments

[Roger Knights]

More shade!

2009 Sep 03 09:24 AM

[Mad Hedge Fund Trader]

pyi. US stocks are now the most expensive they have been in seven years, and never really got cheap during the March low, just fairly valued. At least I have some good company in my views, which are also shared by David Rosenberg of Gluskin Sheff, the former economist at the late Merrill Lynch. The “faith based” rally is now discounting a GDP growth rate of 4.0%, which has a snowball’s chance in Hell of actually occurring. This is up dramatically from the 2.5% growth rate the S&P 500 was discounting when the index was at 667. The best stock market rally since 1933 added an unprecedented eight PE multiple points to stocks, and there is now more risk in the market than the 2007 peak. Underweight portfolio managers and momentum driven day traders are to blame. It’s what happened after the 1933 rally that scares me. Needless to say, stocks offer no value here. You can sign up for David’s well thought out research for free by going to his website at www.gluskinsheff.com/.

2009 Sep 03 11:08 AM

[mbkelly75]

While it is true that Sept and Oct are historically the worst months for stocks - they have gone up in these months before also. Interestingly, these same two months are also historically the BEST months for Gold (likely Silver also - but I would not swear to that). Keep in mind, that John Templeton was the first one to say "There is always a Bull Market somewhere!" It was true when he first said it and it is still true now. Look for the Bull Market - where ever it might be hiding - and put your money where it will do you some good.

2009 Sep 03 08:58 PM

[Old Trader]

"Companies have cut costs to such an extreme that any incremental growth will yield large profits, encourage an inventory rebuilding process, and in turn spark even higher expected growth."

True enough, but umless top line numbers also improve, inventories will be kept on a tight leash, so we're looking at a one time "bump", in that case. If companies are foolish enough to start cranking up production to build inventories without such growth in demand, we can add the effects of an "inventory liquidation" recession/slump on top of the existing credit induced one....definitely not a good thing to have happen.

2009 Sep 04 08:29 PM

[Mistrofan]

IS not about the "cost" is rather about the financing structure of those companies. From what I can see,from the merging markets to the more developed countries, most companies are still over-indebted. And this structural problems will re-arise in the future. For the time being almost everyone tries to remember the good ole times from before Lehman - nd that is exactly why everyone trries to forget (unfortunatelly) the real problem that brought us here: OVER-INDEBTEDNESS, easy money and unsound monetary policies.


On Sep 04 08:29 PM Old Trader wrote:

> "Companies have cut costs to such an extreme that any incremental
> growth will yield large profits, encourage an inventory rebuilding
> process, and in turn spark even higher expected growth."
>
> True enough, but umless top line numbers also improve, inventories
> will be kept on a tight leash, so we're looking at a one time "bump",
> in that case. If companies are foolish enough to start cranking up
> production to build inventories without such growth in demand, we
> can add the effects of an "inventory liquidation" recession/slump
> on top of the existing credit induced one....definitely not a good
> thing to have happen.

2009 Sep 04 11:31 PM