Jonathan Davis

Investment Special: Contrarianism pays

When pessimism prevails, it’s probably time to buy

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When pessimism prevails, it’s probably time to buy

If one thing puzzles private investors more than anything else, it is the extraordinary capacity of the stock market to move in ways that appear to follow no discernible logic. ‘Profits Up, Shares Tumble’, or even ‘World War Declared, Stocks Rise’: such headlines understandably confuse the uninitiated. But in reality there’s nothing strange about this pattern of behaviour, and understanding it explains why being a contrarian — going against the thrust of expert professional opinion — is so often the key to the greatest investment success.

The reason markets often move in mysterious ways is that in any well-functioning market, prices are set to anticipate future changes, not to pass judgment on the status quo. Whether it is the outcome of wars, the onset of recessions or future sales of the new iPad, market behaviour is typically a function of how reality stacks up against prior expectations, not a verdict on reality itself. Sometimes markets are extraordinarily successful at foretelling the future, and at other times spectacularly hopeless. Many years ago Professor Paul Samuelson joked that markets have predicted nine of the last five recessions. The wisdom of that crack has been seen many times since.

When they do get things right, however, markets can do so long before conventional opinion as reflected in the media, at the boardroom table or in the land of punditry, has arrived at the same conclusion. For all the money and time they spend on research, this rule applies more to investment institutions than to almost any other field of professional activity. The sharpest turning points in markets invariably come when the majority of professionals, like the garrison at Singapore in February 1942, are expecting something completely different.

The hedge fund manager Barton Biggs, a former US Navy officer, has chronicled this phenomenon at length. His research into the behaviour of financial markets during the second world war, in Wealth, War and Wisdom (2008), demonstrates that the stock market was uncannily successful at foretelling the tide of military events, long before political, financial or military intelligence (that well-known oxymoron) had arrived at the same conclusion. He noticed that the British stock market bottomed out in the summer of 1940, just before the Battle of Britain; that the US market only turned up decisively in late May 1942, during the Battle of Midway; and that the German stock market reached its wartime peak in early December 1941, just as German forces were approaching the outskirts of Moscow.

In hindsight we can see that these were the three great turning points of the second world war. But at the time it was far from obvious to anyone in government, the military or the media that this was the case. There was certainly little hint of it in political memoirs or military despatches. Most professional investors in England spent the war worrying about the potential consequences of defeat, not the rewards of victory. You would have had to be remarkably brave to have ‘shorted’ the German stock market in late 1941, or called the bottom of the UK market in 1940. Yet history suggests that trusting in the ‘wisdom of crowds’, the notion that a market price can be a better guide to action than individual or aggregated expert opinion, might have pointed you in the right direction.

Is something similar now happening in the eurozone? The Greek debt crisis has been an unfolding horror movie since May 2010, but whether or not you believe the euro has been saved from imminent collapse by the latest actions of the EU, IMF and European Central Bank, the stock market has already brought in an interim verdict. Since their autumn lows, the stock market in the US (where the economy is also improving) has risen by 25 per cent, the UK by 19 per cent and most European markets by a similar margin. The Greek stock market has risen 20 per cent in less than three months.

And yet, with the exception of the Greek market, the turning point in the current rally was back in the first week of October: in other words a month before the disastrous Cannes summit when Mrs Merkel and President Sarkozy were forced to confront openly for the first time the prospect of a Greek default and the collapse of their cherished project of ever-deeper political integration. In the weeks that followed, professional investor sentiment about the eurozone could hardly have been more negative. Fears of a second global financial crisis dominated every newspaper and every morning meeting in the City.

It was not until the announcement of the ECB’s game-changing three-year liquidity scheme for banks in December that it was possible to construct a plausible explanation for greater optimism about the prospects for Europe. And even then, to bet on it required overlooking the official confirmation that most of Europe was indeed entering a new recession, of as-yet unquantifiable depth and duration. Most City economists, and most professional investors, missed the start of the current rally completely.

Of course it’s too early to say whether this short-term rally will turn into something more enduring. Most expert opinion, it seems, still doubts it. Bond market investors remain gloomy. But could you have foreseen such a move? Yes, provided you accept the adage of the late Sir John Templeton, a hugely successful investor, that ‘the best time to buy is at the point of maximum pessimism’.

Tracking investor sentiment is one of the essential tools of the contrarian. One widely followed statistical indicator, for example, measures the balance between bullish and bearish investment advisers in the United States. As with recessions, such indicators are a far from infallible guide to action. Yet this one tells us that at every major turning point in the market over the past 20 years, majority professional opinion has been at the other extreme — bullish when the markets are about to fall, pessimistic when they are about to rise.

In October 2011 the percentage of bearish advisers reached its second highest level for several years, a classic contrarian buy signal. Now, it has to be said, the pendulum has already started to swing towards the opposite extreme. Being contrarian, in other words, won’t always tell you when to buy or sell; but if you want to catch the biggest turning points, you simply can’t afford to have the consensus of opinion on your side.

Jonathan Davis is the founder of Independent Investor.