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January 23, 2006

Contrarian Bandwagons

John P. Hussman, Ph.D.
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Quick note - I'm happy to report that as of last week, the expense ratio for the Hussman Strategic Growth Fund was lowered again, to 1.14%. The expense ratio of the Fund is affected by assets, fee breakpoints, and other factors, and may increase or decrease over time. Please also note that the Prospectus of each Fund is available by clicking "The Funds" menu button from any page of this website.

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One of the challenges of investing is when to move with the crowd and when to move against it. While it's taken as common wisdom that contrarian investing (placing trades that are on the opposite side of the “crowd”) is a profitable strategy in the long run, the historical evidence suggests that a persistently contrarian approach – jumping on the contrarian bandwagon, so to speak – isn't always optimal.

In fact, the data tend to show that big spikes in bullish sentiment occur near the beginning of most bull markets, and that this broad bullish sentiment is on the whole, correct. As I've noted before, the most useful contrarian signals are not based on high bullishness alone, but on high bullishness that occurs when the intermediate-term performance of the market (say, over the prior 6 months) has been relatively tame. From that standpoint, the latest 57.3% bullish percentage reported by Investors Intelligence seems excessive.

The January issue of Science includes an article on bounded rationality in economic games, and has interesting implications about contrary investing. Economists Colin Camerer and Ernst Fehr explain that “strategies are complements if agents have an incentive to match the strategies of other players. Strategies are substitutes if agents have an incentive to do the opposite of what the other players are doing.” (For some reason, we economists like to call normal people “agents”… we tend to call agents “spies”).

A contrarian investment strategy is a “substitute” strategy. Games that favor this sort of strategy are ones where a limited number of rational individuals can produce rational-looking outcomes even if not all the other players are rational. In contrast, when a game favors complementary strategies, “a small number of irrational individuals may cause outcomes that are completely at odds with the rational model.”

The problem is that the stock market doesn't seem to persistently prefer one strategy over the other. “As a result,” write Camerer and Fehr, “well-informed traders cannot always guarantee a profit at the expense of traders with limited rationality. In fact, institutional constraints such as performance pressure and impediments to selling shares short mean that if stock prices are bad estimates of the value of a firm, large well-capitalized investors cannot always guarantee a profit by betting against the market… So trading strategies are complimentary when rational traders have an economic incentive to go along with the crowd for extended periods of time.”

It's precisely this occasional incentive to use “complimentary” strategies – going with the crowd – that makes investment strategies based on valuation alone or contrary opinion alone unreliable. Rather, it becomes optimal to consider the strength of other investors' willingness to “go along with the crowd” and accept risk.

The way we do that here is to look at the quality of internal market action across a wide range of securities, industry groups and investment types (not only stocks, but also Treasuries, corporate bonds, credit spreads, international stocks, and so forth). In general, investors express their broad willingness to take risk by lifting all boats in a fairly “uniform” way, while they express growing skittishness by “taking out” various sectors of the market and creating a sort of “turbulence” in market internals. (Note that our focus is on internals, not solely on the major indices, which can be poor indicators of investor risk preferences in and of themselves).

Market Climate

As I noted last week, the behavior of the market in the short-term could provide a lot of information about investors' preferences toward risk. On one hand, valuations remain unusually unfavorable, and sentiment remains overly bullish. At the same time, however, we've seen some fairly good internal action in recent weeks. Although Friday's dismal performance for the major indices was accompanied by 2332 declining issues and just 990 advances on the NYSE, that ratio was actually fairly good considering the depth of the decline. Meanwhile, 243 stocks registered new highs on Friday versus just 33 new lows.

Against that, we did observe a fairly abrupt momentum reversal last week, and the plunge in the markets' speculative darling (Google) was also an indication of skittishness. It's also a negative event for the market to break its December low in the first few weeks of January. The Dow did last week, and the S&P 500 is not far. All told, the recent evidence was overly mixed, so we require more information before concluding that investors' preferences toward risk are resilient enough to warrant an exposure to market fluctuations. For now, the Strategic Growth Fund remains fully hedged, but it's possible that we could move quickly to a 20-30% exposure if the evidence warrants a shift in position.

In bonds, the Market Climate remained characterized by unfavorable valuations and unfavorable market action, holding the Strategic Total Return Fund to a relatively restrained 2-year duration. Housing starts weakened last week, but that alone is not enough to jump to conclusions of an oncoming recession. Credit spreads (specifically, if corporate bond yields and commercial paper yields rise sharply relative to Treasury yields) and the U.S. dollar (specifically, weakness against the Asian currencies) remain the most important factors to watch in evaluating a shift in recession probabilities. For now, the evidence clearly indicates weaker oncoming growth, but not yet a high-probability recession.


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