The Aleph Blog » Blog Archive » A Note on Contrarianism and Bubbles

A Note on Contrarianism and Bubbles

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

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…

Okay, one semi-practical application, and then this article ends.  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.






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3 Responses to A Note on Contrarianism and Bubbles

  1. James Dailey says:

    Great post David. You point on the US dollar is especially insightful in my opinion. The anti-dollar rhetoric is certainly heated in the short term, but over the long term the aggregate behavior of investors is still very bullish towards the dollar. How many people do you or other readers know that have taken pro-active actions to diversify outside the dollar into other currencies? Retail money has flooded foreign stock mutual funds but that is likely more due to performance chasing than an explicit weak dollar play. The liquidity and volume of the Rydex Currency shares is still quite low. As you succinctly state, foreigners have just started to reject US assets. Where is the buying power going to come from?

    One argument that is pro-dollar is that in a debt deflation people will have to bring money back to the US to pay back debt. On the margin that seems right to me but is it enough to outweight the massive foreign flight and the potential flight of US investors into other currencies if fear continues to grow? It should be fascinating to watch!

  2. Leisa says:

    David, I read you on Real Money, and I did not know that you had your own blog. I feel like I’ve found a jewel on the beach!

    With regard to the invest outside the US, this strategy has been widely touted for sometime–at least from the 10-15% of one’s portfolio.

    I have to wonder that with the dollar in Filene’s basement, and not necessarily quality at a bargain, that once it bottoms, would THAT be the sign (as well a prudent) for foreign investment in our stocks to come in to our markets?

  3. David:

    Your point is exactly… on point. I have spent a lot of time as of late reading Jim Rogers. Of course Jim Rogers’ pronouncements alway prove quite prescient but are often ill timed. The problem with seeing bubbles and shorting them is of course remaining solvent, or at least keeping the faith once it seems the bubble should have burst long ago.

    The next bubble I will be posting about is China. Not that China is not a great growth story, but it has run too far too fast. Inflation is running rampant there and it is highly unlikely that their communist government can manage this type of growth without a major crash, our government certainly hasn’t been successful at doing so.

    I intend to start layering into the shorts after the 2008 Olympics. All of the coverage leading up to and during this event will undoubtedly attract innumerable amateur investors… more amateur than myself.

    Of course, being contrary can also mean buying. Bottoms which is a far safer prospect. On this front Home Builders and Mortgage lenders will soon be ripe for the opposite side of your previous observation.

    http://www.1440wallstreet.com/index.php/site/comments/would_sun_tzu_short_this/

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


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