Romanticizing that you are a contrarian when you are indistinguishable from consensus can’t be good.
The quote above comes from Adam Parker, Morgan Stanley’s U.S.equity strategist and director of quantitative research. He set the Internet abuzz this past weekend with a research note in which he wondered why he keeps getting questions from money managers about why stocks rose in the past two months and what will happen next. Most, he said, preface their queries by noting that they are contrarians. They then proceed to ask the same questions:
What is this price action telling you?
What are other investors asking you about?”
How are other people positioned?
What’s the current sentiment?
The belief among many managers is that their perspective is unique or contrarian, while everyone else’s is mainstream, seems to be surprisingly common.
Therein lies the paradox of looking at sentiment data. Everyone thinks of themselves as above average, just like the children of Lake Wobegon. Of course, believing yourself above average is a very average thing to believe.
Let’s use Parker’s comments as a reminder about why it is only when sentiment data hits extremes that it has much use as a signal for the above-average investor.
Recall our earlier admonitions on the topic:
One of my favorite pastimes is dissecting accepted Wall Street wisdom to see if it contains any value for investors or traders. Often, upon examination, the widely held beliefs turn out to be closer to magical thinking than financial acumen . . . One of the more recent examples is the way some analysts use data on sentiment to determine how much an investor should allocate to equities. The problem is that the sentiment data is inconclusive and sometimes contradictory. There is no signal within the noisy data.
Remember, most of the time, the contrarian investor is wrong. The vast majority of the time, the market is the crowd. Hence, making a bet against the crowd means you are fighting the market. The majority of investing dollars are the fuel that moves stocks and bonds along their long-term, multiyear trends. It is only when sentiment reaches terrific extremes that taking a position opposite the crowd can potentially produce a huge score. Even then, the timing is very, very tricky.
As we learned in “The Big Short,” the folks who made the contrarian bet against subprime mortgages and derivatives still had to absorb a lot of punishment before their wager paid off. Even when the market finally moved their way, the index that tracked this asset class took a long time to catch up to the reality of the meltdown.
Right, but even a little early, is a very difficult trade to maintain.
Perhaps this is the reason that not many assets are managed purely on the basis of sentiment. Most of the time, sentiment correctly reflects the positioning of most market participants. It is beta (market-matching returns). Occasionally, it is spectacularly wrong, and that is beta as well. Hence, if you are pursuing an index-based strategy of beta (as I do) and not trying to outperform what the markets give you, there isn’t a whole lot you can do about sentiment.
Taking what the wily Mr. Market offers means that at times you will be buying when sentiment reaches an exuberant extreme, and at other times you will be buying when the market is in the depths of despair. The good news is that regular rebalancing allows something of a contrarian trade, selling a bit of what has run up and buying a bit of what has gotten clobbered. Do that for a few decades and theacademics promise that you will pick up anywhere from 50 basis points to 100 basis points in additional returns. It’s the closest thing to a free lunch in investing.
The big problem with sentiment as an indicator is that the data is often noisy and inconclusive. An even bigger issue is that some managers think they are not part of the crowd that produces this noisy, inconclusive data. This helps explain why so many managers — believing themselves to be contrarians when they are really holding a consensus view — so rarely outperform the market.