“For my part I know nothing with any certainty, but the sight of the stars makes me dream.” - Vincent Van Gogh
Whenever the investment community believes with 100% vigor that the future is known, it’s time to start thinking the other way. At its core, contrarianism is about identifying the most extreme certainties, and positioning for the opposite under the idea that the bigger payouts occur when fewer people are betting on the pot. Certainly the crowd tends to be right on average, but at extremes the biggest money is made by the few who are brave enough to counter the obvious. The one certainty when it comes to markets is the idea that extremes reverse, as cycles change and new leadership emerges.
It is never easy to identify extremes, except perhaps through the length of time a particular narrative has been told. I believe the last three years can be summed up very easily: an environment where 1) the Fed is good for stocks, 2) there is low volatility, and 3) US large-caps are the only real place to make money. The conviction in the continuation of these three truths makes the long-term actually quite predictable – simply flip everything to its opposite. The next few years are more likely to be characterized as one where the Fed is actually detrimental to the US story, there is higher volatility, and large-caps are no longer the only game in town.
Because we live in the small sample of the day-to-day however, it is extremely hard to wait for that future to come as we hold on to the certainty of the past as an anchor for the future. So we keep grasping on stubbornly when logic dictates that we shouldn’t. The SPDR S&P 500 (N:SPY) declines? Buy the dip! Fed is going to keep rates lower for longer? Bullish! It has become too obvious, and as such then cannot possibly be a way to generate long-term wealth. Just because the crowd is right on average doesn’t mean that that is the most efficient way to make money. After all, if investing with the crowd were a way to generate wealth, everyone would be much richer than they are now.
From the standpoint of quantitative research, which does not rely on narratives, the near-term has been dominated far more by pulses of emerging-market strength, and defensive positioning. The indicators used to manage our Morningstar 4 Star overall rated ATAC Inflation Rotation Fund (Ticker: ATACX, rating as of 9/30/15 among 234 Tactical Allocation Funds derived from a weighted average of the fund’s 3-year risk-adjusted return measures) have largely avoided US equities this year as momentum fails to stick despite the narrative still expressed by others about the future. While our strategies are largely built off of short-term indicators and not off sentiment, qualitatively it makes sense to believe that this is more likely to continue for some time given extreme conviction about how the future will look by the vast majority of market observers.
The best retrospective thoughts based on market behavior week over week come not from the week over week performance of the market, but the underlying thread of belief that drives market movement on average. We can talk about what happened that caused stocks to go up or down in the last 5 trading days, but it is much more helpful I believe to take a bigger picture view of where we are in the cycle, and how to make money off the next one. It is impossible to know the exact moment that change happens, but we can begin to train ourselves into preparing mentally for it before it’s too late. Some can do this following metrics like those discussed in our research papers (click here to download).
The majority, however, need a new story to replace the old one we’re so used to reciting.
Opinions expressed are those of the author and are subject to change, are not intended to be a forecast of future events, a guarantee of future results, nor investment advice.