Blog Post

                Two weeks ago I discussed contrarian thinking.  Most investors agree that the path to profits is achieved by taking an approach that differs from others.  For this reason, most consider themselves contrarian by nature.  However, taking a different approach does not make one a contrarian investor.  The key is to take an approach that is both different and correct.  Only when doing so can one expect to profit while others suffer.

                Knowing there is a subtle difference, I will use an example to illustrate the point.  Imagine we are sitting inside our homes during a blizzard.  As the snow stops falling, we decide to go outside.  Most people would wear layers of warm clothes to protect themselves from the harsh weather.  Even though this would be the consensus view, it would be the correct approach.  Someone trying to be different and viewing themselves as a contrarian thinker would go outside in sandals and a bathing suit.  Obviously, this person is not an individualistic, contrarian thinker, but a stubborn person making unwise decisions.  Being exposed to harsh weather with little protection results in discomfort, sickness or worse.  The same logic can be applied to the financial markets.  Taking a stance that is wrong and maintaining that stance against all odds is foolhardy and stubborn.  All that can be expected from such action is swift and frequent losses.

                Considering the slight subtlety above, we must understand what the group consensus is, how groupthink could be wrong and what the potential profit actions would be.  Along those lines, I would like to discuss two major topics, what the consensus opinion represents and how a contrarian investor would position and profit from them.

                The first area to discuss is commodity prices.  Beginning in 2004, I took a 20% portfolio allocation in commodities.  My investment decision focused on both the future expected gains in commodities themselves as well as the diversification benefit received from a commodity investment.  In January 2004, the CRB Commodity Index stood at 258.  Today it trades at 455 - a gain of 76%.  My view has always been that the increase in prices reflects the supply and demand of the world's markets.  As emerging economies industrialize, the need for commodities increases.  China has shown that building booms drive the need for iron ore and coal.  Populations who had lived in poverty begin to acquire wealth and want to upgrade their lifestyles.  Among the first goals for this group of people is better quality food.  This desire increases the cost of wheat, soybeans and other foodstuffs.  The dynamic of commodity demand continues as oil is needed to for transportation and precious metals are acquired as a symbol and store of wealth. 

                Seeing China, India, Brazil and numerous countries grow rapidly; the demand side of this equation is large and growing.  Unfortunately, supply has not kept pace.  Worldwide, oil is becoming harder to find and more difficult to extract.  Droughts in Australia and floods in the United States have shown the fragile nature of agriculture markets.  Despite high gold prices, producers have not brought much supply to market.  Limited supply coupled with rising demand drives higher prices.  Until the laws of economics are invalidated, this relationship will hold.

                As we all know, prices can rise and fall beyond the true value of any good.  The consensus opinion on commodities is that the current price rise has outstripped the supply/demand relationship and that current prices represent a bubble.  The bubble view has gained such prominence that Barron's has published two cover stories in the last three months (March 31st and June 23rd) describing how we have reached bubble status and must prepare for the bubble to burst. 

               Knowing that most are calling this price increase a bubble that will collapse, what should a contrarian investor do?  I remain a believer in the long-term fundamentals of the commodity markets.  While the increase in prices has accelerated lately, the story is intact.  Demand is growing and supply is limited.  As the emerging markets grow, they will demand fuel and food to satisfy their populations.  The demand pressures create inelasticity where prices can remain high even after supply grows. 

              As I learned years ago, the best way to invest in a bull market is to maintain your position.  Recently, I have used the Powershares DB Commodity Index ETF (DBC) as my commodity investment vehicle.  Looking at a chart, we see many instances of quick, painful declines.  Had an investor panicked at each decline, they would have surrendered their position and missed the next move higher.  A better approach is to live with some volatility, hold your position and let the fundamentals works in your favor.  Having said that, it is also prudent to maintain your position in a size that confirms with your portfolio goals and risk tolerance.  Starting with a 20% portfolio allocation to commodities in 2004, I have scaled that back to a current weighting of 10%.  As commodity prices have risen, I have consistently sold pieces of my position to maintain a risk profile that I am comfortable with while still benefiting from the increase in prices.

             A second topic of key interest is the ability of the Federal Reserve (Fed) to manage the economy.  During the tenure of Alan Greenspan, investors became enamored with the ability of the Fed to cure all economic ills.  Inflation was low, productivity was growing and asset markets behaved well.  Whenever turmoil occurred, the Fed would devise a way to quickly cure the pain and allow investors to prosper.  Over nearly 20 years of consistent medicine, the investment community became convinced that central planners can adequately manage a capitalistic economy.

             As Greenspan passed his role to Ben Bernanke, investor faith remained largely intact.  When the credit crisis began unfolding during the summer of 2007, Fed interest rate reductions led to stock market rallies that allowed the Dow Jones Industrial Average (DJIA) to reach an all-time high of 14,164 on October 9th, 2007.  Even though that peak was short lived, the Fed has taken increasingly aggressive and creative actions to bolster the stock market and the economy.  Recent proclamations from various Fed governors indicate that they are now focusing on the value of the dollar.  From there, many are pushing for greater influence for the Fed to oversee investment banks.  It seems that faith has been put in one central organization to increase its grasp over all aspects of the economy and financial markets.  Sadly, few have questioned this expanded mandate and continue pushing for more intrusive regulation.

            Considering that the DJIA has retreated 16% over the last nine months, you would expect investors to question the Fed's ability to cure all ills.  Investors have not taken that step.  Having seen the Fed avert the financial meltdown that would have accompanied the collapse of Bear Stearns, many believe it is a matter of time until growth resumes and the markets push higher.  The relative strength of the NASDAQ and the particular strength of some high profile technology companies (i.e. - Amazon.com, Research in Motion) over the past few weeks show that investors are not prepared to abandon high beta, volatile stocks.  If investors truly believed bleaker times were ahead, they would abandon high beta stocks for the safety of diversified, strong dividend paying companies.  Instead, risk profiles remain high as investors buy what is working instead of what is cheap.  If the Fed does anything to stabilize the markets, these risk seeking investors are looking to position themselves for the eventual rebound. 

             As a contrarian, we must ask ourselves what would happen if the consensus' faith in the Fed is incorrect.  Personally, I see very little the Fed can do.  They have expended a great deal of their ammunition in reducing their overnight lending rate to 2%.  With future interest rate reductions unlikely, a different path would be to raise interest rates to boost the dollar, deflate commodity markets and make US assets more attractive.  In an election year with a weak economy, this approach is unlikely as well.  Instead, the Fed will maintain the current level of interest rates, provide liquidity to financial firms and help avert any further disasters.  What we are left with is an economy that struggles for growth while dealing with persistently high inflation.  From an investment perspective, I expect strong companies to get stronger, innovation to decline and marginal competitors to be merged out of existence.

             In the two examples above, I have illustrated how a contrarian can develop a non-consensus view and apply that thinking to investment decisions.  When investing, innovative thinking is needed to develop profitable ideas.  Look at what most think, consider contrary views and determine ways to profit.  However, you must also remain flexible in your thinking.  Maintaining a losing position because you want to be different is a path to ruin.  Giving up a losing position because the market disagrees with your logic leads to frustration.  Instead, develop a thesis, constantly reassess conflicting data and adapt as needed.  The nimble, flexible investor will be the one who can let correct, contrarian views grow into profitable positions.