Only the Contrarian Survive.

December 16, 2013

"Wall Street people learn nothing and forget everything."
-Benjamin Graham

. . .

"To be in opposition is not to be a nihilist. And there is no decent or charted way of making a living at it. It is something you are, and not something you do."
-Christopher Hitchens, "Letters to a Young Contrarian"

. . .
In between Christmas parties and naps, I read a wonderful piece by Morgan Housel over the weekend. Entitled, "You Win By Thinking Everyone Else is Wrong," it underscored a long-held theme of ours. That is, Wall Street and Main Street sentiment serve as the most effective contrarian indicators available.
Because both, more often than not, move in a direction opposite of success. Let me explain.
Bloomberg reported earlier this year that the 50 stocks with the worst Wall Street analyst ratings at the end of 2011 outperformed the S&P 500 by seven percentage points in 2012. So, whereas most investors fall woefully short of the index, Wall Street's most detestable stocks trounced the benchmark.
This inspired Housel to analyze 2013's top buy- and sell-rated companies, as reported by FactSet, among Wall Street's top analysts. The results? Hardly surprising.
Including dividends, the S&P 500 is up roughly 27 percent year to date. Stocks with the most Wall Street Sell ratings in January are up a median return of 52 percent. So, Wall Street's lowest-rated companies beat the index by 25 percentage points.
Conversely, the stocks with the most Wall Street Buy Ratings in January have returned a median rate of 20 percent, so under performing the index by 7 percentage points. And under performing their worst-rated peers by 32 percentage points.
How about those apples?
From experience, I can tell you that Wall Street, its analysts and its minions of salesmen cum advisors do two things very well. First, they talk investors into buying mutual funds and money managers that do not outperform their benchmarks with anymore regularity than the Cincinnati Bengals. Second, they talk clients into buying positions that the firm's sell-side analysts love. You know how that can work out. Remember Jack Grubman? Henry Blodget?
Housel makes a very telling point when he writes, "One of the most important lessons in all of finance is to understand the incentives of the guy sitting across the table from you."
So long as Wall Street can make billions of dollars each year by gathering assets from investors and then hitting grounders back to the pitcher, there will be no incentive to change.
Remember, among the most bullish calls from Wall Street's institutional equity strategists came in Q1 2000 and Q3 2007. Both were immediately followed by catastrophic bear markets.
Truth is, Wall Street's biggest concern has never been the accuracy of its forecasts, the prescience of its picks, or the financial health of its clients. Otherwise, it would not have sold derivatives that forecast a continuance of the housing boom, even as the firms had begun to bet against it. Nor would the firm's advisors continue to allocate client capital to funds and managers that have no history of outperformance. But, they do permit advisors to spend most of their time on everything but managing client capital.
Look, I get it. Even Darth Vader had to make a living. Funny thing is, you can see the entire mechanism slowly taking shape.
As the market continues to rise, Wall Street has realized that it cannot remain bearish forever. Not five years into a bull market! So, the nation's financial behemoths are suddenly getting on board. Which means that their salesmen cum advisors are getting on board. Which means that Main Street is, five years in, getting on board. Right as the smart money moves toward the exits.
Need anecdotal evidence?
At least five times over the last year I've received calls from friends relating that their acquaintance, who works for a large brokerage firm, was counseling them to get out of the market.
My response? "If your friend at that brokerage is counseling you to get out, then that only bolsters my conviction that this market has legs. Let me know when your friend is bullish."
Suddenly, he is.
In fact, now these guys are pouring in. Right as the economy heats up. As credit and capital flows are approaching all-time highs. As flows into mutual funds have never been stronger. As sentiment soars.
These hyper-bullish indicators tell me to beware. Recall what Buffett said : To invest successfully, you must be fearful when others are greedy, and greedy when others are fearful.
Well, I'm looking around, and people are beginning to look piggish. The fear is dissipating. Replaced by a desire for easy profits. Which flashes a warning indicator. Be prepared to exit.
U.S. equities have reached expensive heights. More so than investors realize.
The median prices-to-earnings ratio for the S&P 500 is nearing record levels. Well above its peak in 2000. Back then, only a handful of large-cap stocks traded at large P/E ratios. They pushed the average P/E to nearly 50. But, the median P/E never approached those levels. Today they do.
Now above 25, even the Shiller P/E sits at a record high.
So, Wall Street and investor enthusiasm have skyrocketed. Valuations have followed. The Fed continues to pump capital into the system. That cash continues to find its way to Wall Street. Value line reports that only 14 percent of investment advisors are bearish. At 2.5 percent of GDP, margin debt at the New York Stock Exchange has reached the highest level in history. American Funds, Fidelity, Dodge & Cox and others are seeing massive inflows. The herd is in motion.
Sounds ominous.
Time to tighten your trailing stops. Check the landing gear on your downside protection mechanisms. Perhaps its may be nothing more than a random stench. But, something smells. May be nothing to worry about. Could be months, perhaps years away. But something has raised our hackles.
If you read our five-part series, Investment Perspectives: The Road Ahead, you'll recall that there were four areas of the market in which we believe that targeted allocations offer solid short- and long-term opportunities. Regardless of what lay ahead. The shale and natural gas renaissance. China. U.S. small-caps. And 3D printing and other next-generation technologies. Come hiccup or earthquake, these opportunities will continue to serve prescient investors well.
Further, those areas that were especially out of favor this year -- gold miners, teen retailers and coal miners, to name a few, may be next year's high flyers. The darlings of their indexes. The analysts hate them. Main Street investors treat them like lepers. So, they'll likely outperform the benchmarks by two and three times.
That said, most will never allocate a dime in their direction. Because the mutual funds and blue chip client companies recommended by the brokerages will be charging like a herd of buffalo. Running in lockstep with the markets. Taking investors up to and over the cliff.
Until investors are willing to make decisions that fly in the face of conventional Wall Street investment wisdom, they will never have a shot at outperforming the market benchmarks.
When Billy Bean introduced Saber metrics to the Oakland As, the old scouts mocked him. The As went on to post the best record in baseball for the next decade.
When Winston Churchill questioned Neville Chamberlain's placation of Hitler's German in 1939, he was branded a blowhard. He went on to repel the German blitzkrieg and save England.
When Jerry Seinfeld proposed doing a prime time network television show about four people who spend their lives doing nothing, networks executives said it would never work. "Seinfeld" went on to become one of the longest running, successful shows in television history.
Point is, taking the contrarian's path can be discomfiting. Difficult. So, if you're uncomfortable moving against the herd, then being a contrarian is not for you. If you value the comfort of the crowd over the lonely rewards of prescience, then by all means, go with the flow.
However. If you're comfortable with stepping back. Taking a wholly objective, dispassionate survey of the situation. Then, acting upon your individual analytical instincts. Then, perhaps you are a contrarian.
If you study the scene and recognize the errors and omissions so prevalent in the group think that drives societal trends, then perhaps you are a contrarian.
If you recognize that every table has a patsy. And when you cannot spot him, you realize that perhaps you are he. Then you just may be a contrarian.
Yet, most investors find the process too difficult. They simply don't care to do the heavy lifting. Would prefer that others, regardless of the agenda, do it for them. Regardless of how consistently incorrect those others have been.
There is a singular lesson that forever eludes most. Yet, is grasped by contrarians. And so guides most contrarian decisions.
There is no free lunch. And by the time the masses gather around the banquet table, whatever leftovers remain will have grown soggy and cold.

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