Being contrarian

BNP Paribas International Private Bank independent consultant discusses why homo economicus is as elusive as the Loch Ness monster.

Have you heard of Homo Economicus, the star of classical finance theory and its Efficient Market Hypothesis? He is the man who, in the blink of an eye, is able to process huge amounts of data, draw rational conclusions, and can act without any emotion-24 hours a day, 7 days a week. Homo Economicus has an Oscar-winning role in the aforementioned theories, for their mantra is that all investors should, as a group, act the same way he does.

But do they?

For many years, academics thought they did. Now Behavioural Finance is attempting to prove the opposite. In the world of Contrarian Analysis, Homo Economicus is not a star; he is as elusive as the Loch Ness monster.

Perhaps you should meet a new actor: Homo Sapiens (Psychologicus). He has beliefs. He has bias. He has flaws. He not only makes mistakes while processing and acting upon data, but does so in a way that is predictable. He is a social creature who strives to belong to a group and to feel reassured. In the group to which he aspires, attitudes and behaviours tend to be similar-due to the simple fact that, as Keynes noted, "It is much easier to fail conventionally than to succeed unconventionally." These characteristics give the Contrarian a script of powerful tools to predict market movements-to predict not just Act I and II of a financial play, but to predict the ultimate finale: "who done it?"

A key element to understanding Contrarian Analysis is the "Adoption/Diffusion" model (Figure 1~Source: Clue 6).

When a new idea or trend appears on the financial stage, its adoption by investors tends to follow a normal distribution (the green line on the graph). The cumulative number of individuals who have adopted the idea takes the shape of an "S". For the mathematicians among you, this "S" is also called the first derivative of a normal distribution.

In the beginning, few people will adopt this new idea or trend. Acceptance accelerates, however... reaching a peak at the top of the green line. Finally, the pace of adoption slows, ultimately stopping.

In the financial arena, two Homo Sapiens biases best describe this process: Conservatism and Anchoring. Conservatism implies under-reaction to new idea, while Anchoring implies over-reaction to the new idea. Recent events serve as an anchor for expectations.

The problem, however, is that a Contrarian is also a Homo Sapiens. Every day he struggles against the instinctive desire to think like the group; to avoid the risk of being the only one who is wrong.

When one is a Contrarian, one does not always bet against the mass. As Humphrey O'Neill noted, the mass is only wrong at turning points. Never fight the crowd during a trend. Trends very often last longer than may be rationally expected.

The Contrarian frame-of-mind is suitable as much as for structural market analysis as it is for cyclical market analysis. When speaking of structural issues, the Contrarian is looking to identify widely accepted beliefs, ideas, and themes behind a market movement, looking for the point where investors are fully committed. At this point, there should be no one left who can act on the trend. The idea of buying or selling should (preferably) be based on shaky, theoretical grounds. The famous comment made in restarted relationships that have previously failed applies here: investors (and the lovelorn) say "this time it is different"-a sure signal that their future is plagued with an almost certain repeat of a previous failure in the same domain.

Homo Sapiens expects recent history to be repeated indefinitely...

A long-term trend (Figure 2~Source: Clue 6) acts like a magnet. Once the market strays too far away from the trend, it is likely to reverse in a decidedly cyclical move. Medium-term peaks and troughs are often accompanied by extremes in investor opinion and action.

A good Contrarian actor will identify these market characteristics and take advantage of them.

So our Contrarian can have apparently opposite structural and cyclical views. He keeps in mind, however, that it can be dangerous to bet against structural trends-which is why he often implements well-thought-out stop-loss orders and other risk control techniques.

How would a Contrarian see the current Asian (ex-Japan) market environment? How would he view the current status of equities?

After the 1997~1998 crisis, the Contrarian saw Asian stocks banished from both local and international portfolios. 1998 was a time to be structurally and cyclically bullish. The structural trend has now been identified by the mass, by the majority. Is this a time to be Contrarian? We think not...

Bear in mind that a fundamental differentiating characteristic in financial markets is the gap between an opinion and the commitment to implement it. It's easy to give advice (and to believe in an idea), and quite another to put money behind it to make the opinion a reality via an actual investment.

Individual investors and fund managers, both locally and globally, have not yet become strategic bulls on this market.

This lack of bulls can partially be explained by the current low weighting of the Asia region in global indices such as the MSCI and its ilk. Asia (ex-Japan) is less than 4% of the MSCI world free index-and yet Asia's GDP is, on a PPP adjusted basis, only 20% lower than that of the US!

Another reason for this lack of bulls is the lingering memory of the 1997~1998 Asian crisis. Investors who are burnt (like our lovelorn friends mentioned above) tend to remain cautious before stepping again into the world of investment. The currently high bank-deposit-to-market-capitalisation is proof of investors' shyness.

In consequence, there are coffers of cash available to be committed to the market on a structural basis.

Our Contrarian now turns to the rationales of such a structural trend. There are no shaky theoretical grounds here-indeed there are signs that they are being downplayed by investors. Look anywhere and you'll find assertions such as "The 'Asian decade' is an idea that's been pushed since the beginning of the 80's, but look what happened! I don't want to be burnt again". China is perhaps the only exception to this assertion; its relative performance in the coming years is likely to suffer accordingly.

The Contrarian presents for your consideration several themes:

  • Demography (Figure 3~Source: UNPD, Clue6)
  • The rise of democratically elected governments and the accompanying vulgarisation of credit have created a voting group of middle-class consumers.
  • The increase of wealth. Through the acceleration principal, consumption has increased via the multiplier effect.
  • The trough in price cycle of Real estate prices, enabling the expansion of both consumer and bank balance sheets.
  • The structurally reasonable valuations of equity markets.
Our Contrarian thus sees that all the elements are present to allow him to identify the Asian equity market (ex-Japan) as being in a structural "rising" phase. The Contrarian will be structurally overweighted. The Contrarian can also foresee that Asia (ex-Japan) will in the next 5~10 years considerably outperform "developed" equity markets, notably those in the US.

The Contrarian, however, never forgets cyclical trends. In January/February, excesses were evident. US-traded Chinese closed-ended funds were at a high premium. IPOs and secondary offers in the region were at a high level. There were rapid net inflows into Southeast Asian mutual funds. The Contrarian identifies these events as indicative of a medium-term over extension.

By August, these excesses were partially corrected. The market advance since then is likely to continue into the first quarter of 2005, followed by the emergence of an important (>30%) correction. This correction will frighten Homo Sapiens (recently converted into bulls), paving the way for the next rise in markets. The Contrarian will see that this ascending phase will likely begin in 2006.

Our Contrarian has been brief here when speaking about his role on the world financial stage-but he knows one thing: Southeast Asian equities are in a structurally rising market. He predicts that this trend will likely bring indices much higher than most investors could imagine. He expects an increase of 5 to 10 times in the next decade. He also sees China under-performing the region.

Looking at the near-term horizon, the Contrarian sees from a cyclical perspective that the market is approaching an important top, probably during the first quarter of 2005.

The Contrarian's magnum opus is that he can use investors' cognitive bias to give himself an edge when making investment decisions. He knows that his analysis tool, when used with fundamental analysis, can help assess the validity of the rationales behind market movement.

And in the end he knows that being a Contrarian is not an easy task, requiring constant struggle against instinct... but it is more than worth the effort.