The essence of contrarian investing philosophy is the principle that when everyone is bearish, the market becomes bullish. Conversely, when everyone is bullish, the market becomes bearish. The underlying logic: when everyone is bearish, they have all completed their selling. So there is no selling pressure left. Vice-versa, when everyone is bullish, they have all bought. So, there is no demand left.
Based on this principle, contrarians track sentiment. When opinion is overwhelmingly tilted in one direction, they expect the market to move in the opposite way. While this is logical enough, there are several caveats to implementing contrarian investment methods.
Investing is not a democratic process. One opinion backed with a lot of money, or policy-making power, has more influence than multiple opinions backed by little money. While a contrarian must track opinion and sentiment, he must also weigh opinions carefully.
The actions of major institutional players (including hedge funds) have more predictive value and impact than the actions of small operators and retail investors. Also, when tracking institutional money, you must allow for the fact that some players (mutual funds, pension funds) hold positions through the very long-term, while others (hedge funds, big operators) churn short-term. So you need a sense of “hot” money versus long-term investment.
Another caveat: It is difficult to time contrarian investment. If you enter early, you can lose a lot. You need to be prepared to hold positions until opinion reversal occurs. In practice, this means having deep pockets. Contrarians are long far more often than they’re short.
In technical terms, contrarians trade less frequently than those who operate on more conventional signals. Contrarians make entries and exits close to major reversal points, trying to catch trend reversals as they occur. Modelling this mathematically to create an automated trading strategy is difficult. Every experienced technical analyst knows that creating a trend-following strategy is much easier and safer than creating a trend-reversal strategy.
Therefore, most contrarians also pay heed to valuations. If valuations are not within the comfort zone for the strategy (whether bullish or bearish), it’s better not to be contrarian. Market valuation history tends to be reasonably constant over time because valuations are mean-reverting. The PE and price to book value ratios both tend to be distributed normally within a fairly predictable range.
In late 2010 and early 2011, the contrarians were bearish. All the sentiment signals checked out. The institutional opinion was optimistic, and so was retail. Valuations at an index PE of 22+ were much higher than historically sustainable levels. The macro-economic environment was getting worse with nine months of interest rate hikes and steadily rising inflation. Those who acted upon their instincts and shorted Indian equities have made a packet in the past 12 months.
Time to revisit strategy?
After a year of bearish activity, is it time to revisit the “Big Short”? Let’s try and find an answer to that question using classic contrarian logic.
The institutional attitude is clearly negative but not overwhelmingly so. While FIIs have been sellers for the past year, the selling hasn’t been across the board. The hedge funds have got out, the big overseas investment houses have cut down India weights. But there is still a substantial quantum of overseas investment in Indian equities. Not every FII has shed India exposure.
The domestic institutional investors (DII) have been net positive. This is partly a problem of mandate — they cannot flee overseas. Also, money flowed into Indian mutual funds until the October-December 2011 quarter, when redemptions increased substantially. DIIs cash holdings have to increase with say, a quarter worth of substantial net selling, before one could say that the DIIs are negative in attitude.
Retail and operators are still positive. We can infer this from daily volume breakups. In broad terms, FII net selling has been more than DII net buying which is why net institutional attitude is negative. Those net institutional sales have to be balanced by retail buying. Note that these are sales against delivery, so the counter-party retail buying is at least committed to overnight positions.
In sentiment terms, therefore, I’d say that attitude is negative but not overwhelmingly negative yet. On those grounds, it isn’t yet time for contrarians to enter the fray as buyers. There has to be more gloom and doom.
Valuations: low but not compelling
In valuation terms, PE ratios have dropped to around 16-17, which is close to the long-term average. Historically, these ratios are sustainable. So an investor with a two-three-year perspective should get reasonable returns from the equity market at current prices.
However, these valuation ratios are not compelling either. Indian bear markets tend to bottom in the zone of PE 12-13 or lower. That implies either a potential 25 per cent downside, or a long period of prices marking time while earnings catch up. At current EPS growth rates, by my reckoning, it will take five to six quarters for current prices to reflect 12-13 PE. So, a cursory valuation analysis suggests there is either a substantial downside or substantial potential opportunity cost, if equity prices stay flat for another 15-18 months.
In macro-economic terms, things have gotten worse. Inflation is still high. Interest rates are still high. The RBI has hinted that it might soften its stance and cut policy rates. Then again, it could change its mind. There is absolute policy deadlock: lawmakers have done no substantive legislation this year. Both the overall fiscal deficit and the external debt numbers have gotten worse.
The global situation is fluid. Euro zone is not out of the woods; Arabia is still in conflict. The rupee could see continued violent fluctuation and it may well drop more. The impact on trade if EU collapses or stays in recession would be quite severe. External balance of payments could get dangerous if crude oil spikes due to Arabian civil wars.
A point to be noted is that recovery (in macro-economic terms) will be gradual. We won’t wake up one morning and realise “Okay! The euro crisis is over, the Arabs have settled down and India’s deficits, inflationary issues, etc. have all disappeared.” Improvements will happen incrementally over a period of months. We may, however, wake up one morning to discover that the euro has gone bust. Or that Libya, Egypt, Syria etc., has descended into a new conflict.
My assessment would be, the Big Short still remains a valid play and we’re not really close to a trend reversal point yet. It’s very likely that the first half of 2012 will see a continuing downtrend. Under the circumstances, passive investors should be braced to maintain, or even increase their commitments if the market falls.
Given the above point of view, it would be hypocritical to wish readers a happy new year on the investing front. But things do always get better if you can tough it out in the bad times. So don’t lose heart and don’t panic. There’s every chance that the next 12 months will go better than the past 12.