Beware of Naive Contrarianism

Of all the names I have been called over the years — and there have been plenty — “Contrarian” is the one I am most proud of.

Yet while many people seem to aspire to that label, few manage to truly achieve it. There is a comfort in crowds, and degree of stress relief that comes when you are not out too far on that limb. The Herding instinct is powerful, especially amongst traders, analysts, strategists and economists.

I was discussing this last month with Paul Kedrosky. He noted that many people seem to aspire to that title, and for all the wrong reasons. We talked about how EVERYONE seemed to be expecting a classic September sell off all summer. That expectation seemed to even be the basis of the mild sell off last week.

The contrarian view isn’t betting on the collapse, its looking at what will frustrate the most amount of people. I suspect that a continued rally higher would have that effect, despite the historical post crash patterns.

One thing you should consider when betting against the crowd: They tend to be right most of the time. There are a several things I disagree with in Surowiecki’s The Wisdom of Crowds, but the basic idea that crowds can determine outcomes is undeniable.

Indeed, markets are essentially the net result of the behavior of crowds. When asked why stocks were going down, the old trading desk joke is “More sellers than buyers.” That is as good a definition of a crowd as I’ve seen.

To better explain contrary thinking, I like to describe Wall Street and Markets as a sports stadium filled with fans. The better the team does, the louder the crowd cheers. The louder they cheer, the better the team does. Hence, markets have a large degree of self-fulfilling prophecy in the way they respond to crowd behavior.

Call it what you like — sentiment, reflexivity, feedback loop — for most of the time, the crowd not only determines market direction, IT IS market direction.

The secret to being a true contrarian is identifying when this excited (but orderly) crowd of cheering fans becomes a an unruly mob; Determining the point at which the fanatics become hooligans. Not throwing paper cups on the court, but overturning cars; When the Wisdom of Crowds becomes the Madness of Crowds.

That is when you short a raging bull market, buy into a crash. You hold your nose and make the purchase.

And, it is typically an uncomfortable, outlier position.

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Previously:
Contrary Indicators 2000 – 2003 Bear Market (September 9th, 2003)
http://www.ritholtz.com/blog/2003/09/contrary-indicators-2000-–-2003-bear/

Understanding Contrary Indicators (May 31st, 2008)
http://www.ritholtz.com/blog/2008/05/understanding-contrary-indicators/

Four Stages of Secular Bear Markets (August 27th, 2009)
http://www.ritholtz.com/blog/2009/08/aftermath-of-secular-bear-markets/