Contrarian investing and trends

“Central principle of investment is to go contrary to general opinion, on the grounds that, if everyone is agreed about its merits, the investment is inevitably too dear and therefore unattractive.”  

 - Keynes

Everyone wants to be a contrarian, but it is hard to do. Being contrary is not enough. You have to have a rationale for your difference of opinion.  Being contrary by thinking the opposite of convention is a recipe for disaster if it is not grounded in data, facts, and a workable model. Could a trend-follower ever be a contrarian, or is the trend manager the poster child of the anti-contrarian, the lemming?

Since there are always buyers and sellers in markets, perhaps there are always contrarians - every buyer is a contrarian to the seller. The trend-follower as contrarian is actually a key part of what it means to be a trend manager with respect to general opinions. Sounds silly, but it can be true. 

The trend manager can be a contrarian to public opinion because the focus is on price and not what others think. If opinions are the same, but prices are doing something different it is worth focusing on what prices are saying. Prices may prove to be wrong, but it the process of being marked to market which tells us that it cannot be ignored.

Price should be the weighted average of all opinions, so it seems odd to think in terms of being a contrarian, but in reality some of the most money made from trends occurs when market views are inconsistent with price. Keynes refers to general opinion but trend-following or systematic managers grounded in just looking at the data can be at odds with general opinions. Systematic managers are focused on data - it could be prices or it could be fundamentals, but the decision process is data driven not opinion driven.

Look at the simple example of current market pundits and stocks. There is a vocal case for stock over-valuation. The drum beat of valuation has caused many to cut equity exposures, but in reality keeping with the trend has been a more successful strategy. Prices are telling us that current opinions are wrong or at least not valid in the current environment. Opinions may prove to be correct at some time in the future, but trend-following focuses on the here and now presented by price data. It may not be perfect, but it is a decision process that can be structured with precision.

Keynes on liquidity and markets

“Of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of ‘liquid’ securities. It forgets that there is no such thing as liquidity of investment for the community as a whole.” 

-Keynes 

What will be the biggest risk for 2015?   It will be liquidity. There will be more one-sided risks based on any significant changes in beliefs, but these shifts will be heightened because liquidity will be missing.  There will not be any dealers standing on the other side of the market. So should investors  pay a premium just to have liquidity? The answer is no, but shifting to less liquid markets is not going to be a solution either. Investors just have to work under the assumption that liquidity will not be present at the most critical times and the Fed may not have the tools to solve the problem. 

I am in the liquid alternative space, so do I have a fetish for liquidity? I just know that liquidity will be scarce when you need it so you better plan for every exit. That does not mean that you have to have stop-losses on every trade. Markets can easily blow through stops so it can provide a false sense of security. The only ways to really protect against a liquidity crisis is through diversification and limiting leverage. Diversification is simple - never place too much in any trade and assume that correlations will go up in a crisis. Leverage is also straight-forward - do not use too much leverage no matter what is the return to risk. 

Everyone cannot have liquidity, so it is critical to monitor markets for reversals. If trends change, the response has to be swift and without hesitation. Cut or reverse positions. Use the liquidity first because there may not be much behind it in the short-run. 

No dealer profits and the potential for a liquidity crisis

Major bank dealers are seeing continued erosion of profits since the Great Financial Crisis. There is no more proprietary trading with the Dodd-Frank rules. Volatility is down and trading volumes have declined. It is just hard to hit ROE targets in traditional, fixed income, commodity and currency trading in the current environment. 

Many investors will argue that this is a good thing. Banks have been making money from clients for decades so let them suffer. Nothing like seeing Wall Street titans taken down a notch. But, if you are interested in systemic risk, you want to think through the implications from this profit decline.

Dealers make markets in strategic asset classes. The bond market is the place for safety in a crisis. Currencies are the biggest trading markets in the world. Commodities are a critical input to the real economy. The trades that can go through these markets can be very large and they need immediate liquidity. If there are no dealers, and make no mistake, banks are the only intermediaries with the balance sheets to provide liquidity, there will be limited liquidity in these markets. Futures traders, HFT traders, and hedge fund speculators do not have the capital to provide liquidity in the short-run. They do not have the relationships that will allow them to take trading risks that will be paid back in other ways. 

If banks start to streamline operations, cut head count, and reduce trading capital, there will be a liquidity impact and this will lead to true systemic risk. This market readjustment is happening now. A liquidity crisis is exactly what the Fed wants to avoid, yet the system may have gotten riskier.

Peter Lynch on anticipating corrections

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.

- Peter Lynch 

Taker risks, just make sure that the risk are prudent. The correction is the exception not the norm. Realize that markets will correct, but the most likely scenario is that they will maintain the status quo. If a market is trending up, it will likely continue to move in that direction. It will change, but trends will last longer than expected. A focus on the current market environment is better than a forecast on the reversal that is less likely to occur. Peter Lynch was not a trend-follower but it is unlikely he wold fight the market direction under the assumption there will be a change.

One of the key advantages of trend-followers is their willingness to stay in the current market environment and not in the environment of "what if". This could be one of the key distinctions between systematic and discretionary traders.

Nevertheless, every trend-follower has an exit strategy and realizes there is a time to walk away. The exit is usually based on the a reversal of price not based on a fundamental forecasts but on market behavior. There is a willingness to give up some existing profits to stay in a trend until there is an actual sign of a reversal.

There is a higher likelihood of an equity market correction. The case can be made through looking at valuation, length of cycle, and some fundamentals, but if price behavior is telling us otherwise, the disciplined money will stay with the current trend.