Understanding Contrarianism and Bubbles

by: David Merkel, CFA

There is a misunderstanding about contrarianism - that somehow if a lot of people think something, it must be wrong, so you should take the other side of the trade. We can make an exception here for some financial journalists - they are often late to catch onto a story, and therefore the magazine cover indicator does often work.

My point here is that intelligent contrarianism does not work off of what market players think, but how much they have invested relative to their investment policy limits, and the capital that they have available to carry the trade. When there are many investors that have gone maximum long on a given company, that is a situation to either avoid or short, because unless new longs show up, the current longs have no more buying power — it is a crowded trade.

I saw this with housing in 2005, as I wrote a piece on residential real estate that proved prescient. It drew a lot of controversy, but my point was plain. Where would additional buying power come from? In September of 2005, I concluded that we were at the inflection point. One of my theories about inflection points is that there is no good numerical signal of an inflection point, but qualitative chatter undergoes a shift at the inflection points. In that case, I had a series of googlebots trawling the web for real estate related chatter. The tone shifted in September/October of 2005, but it was largely missed by the media and the markets.

Though I have nothing written on the web on the Internet Bubble, the qualitative chatter change that happened in March of 2000 was commentary from a variety of companies that had relied on vendor financing were turned down by their vendors. That was new, and it indicated a scarcity of cash. My rule of thumb on bubbles is that they are primarily financing phenomena; bubbles pop when cash flow proves insufficient to finance them.

Now, with both the residential real estate and internet bubbles, there were a bunch of naysayers prior to the bubbles. Most were way too early. Keynes observed something to the effect that markets can remain irrational longer than an investor can remain solvent. Risk control is a key here, as well as cash flow analysis. When does the financing fall apart? What will the inflection point, with all of its fog, look like? Where is the weak spot in the financing chain?

Those naysayers were an inadequate reason to take a contrarian position; many of them didn’t have a dog in the fight, aside from intellectual bragging rights. Rather, the contrarian position was to ask what side had overcommitted relative to their ability to carry the positions, and the ability of others to get financing to buy them out.

Where I differ with many permabears is that I am usually unwilling to extend my logic to second order effects. Just because one area of the economy is falling apart, doesn’t mean that a related area will of necessity get blasted. There are dampening effects to almost any economic phenomena, such that you don’t get cascading effects where failure in one area leads to failure in others, leading to a failure of the system as a whole. The exception is of course the great depression, and that was a situation where the whole economy was overlevered. We’re not there today, yet…

One semi-practical application: I get a certain amount of pushback for being bearish on the US Dollar. I’ve been bearish on the US Dollar since mid-2002, when I saw that our monetary and fiscal policy were shifting to aggressive levels of debasement stimulus. Today I heard someone dismiss further US dollar weakness because “everyone knows that.” Well, if everyone knows that, tell it to the foreign investors who are stuffed to the gills with US dollar claims (bonds), such that their economies are beginning to suffer higher inflation.

I see a continued crowded trade here, and I am waiting to see where the pain points are, such that foreign central banks begin to intervene to prop up the dollar. It hasn’t happened yet, and we are within 20 basis points of taking out the all time low in the dollar index, set back in 1992.