The Contrarian Column

Zweig's Lessons
The Wall Street Journal's Jason Zweig wrote a clip-and-save column on Saturday. The article reads like a valedictory--what Jason has learned from 25 years in financial journalism. The key lesson being to zig when others zag.

The natural cycle of investments works like this (my summary, not Jason's):  

1. An asset performs well.
2. Wall Street notices.
3. Wall Street markets that asset.
4. Journalists cover what Wall Street markets.
5. Investors buy what journalists cover and Wall Street markets.
6. The asset becomes overpriced.
7. Investors buy even more of the asset.
8. The asset declines in value.
9. Investors grow concerned.
10. The asset declines further in value.
11. Investors sell the asset.
12. The asset languishes.
13. Wall Street does not market the asset, nor do journalists cover it.
14. Return to step 1.

Jason writes: "In practice, for most of the media, that requires telling people to buy Internet stocks in 1999 and early 2000; explaining, in 2005 and 2006, how to 'flip' houses; in 2008 and 2009, it meant telling people to dump their stocks and even to buy 'leveraged inverse' exchange-traded funds that made explosively risky bets against stocks; and ever since 2008, it has meant touting bonds and the 'safety trade' like high-dividend-paying stocks and so-called minimum-volatility stocks." (No doubt Jason would place risk parity on that list.)

He adds, "It's no wonder that, as brilliant research by the psychologist Paul Andreassen showed many years ago, people who receive frequent news updates on their investments earn lower returns than those who get no news. It's also no wonder that the media has ignored those findings...I long ago concluded that regression to the mean is the most powerful law in financial physics."

Spot on. That's a column I will hand out to prospective investors. 

Two Flavors of Contrarianism
There are two flavors to contrarian thinking: 1) not buying that which is popular, and 2) buying that which is unpopular.

Jason correctly spends his energy on the former, as it's the more useful and reliable application of contrarianism.  Bypassing hot assets doesn't actively profit an investor, and it can extract an opportunity cost as the asset continues to rise, but it may well be the key for long-term results. The math of compound interest rewards those who dodge big losses. Avoiding the very avoidable mistake of owning popular, overbought securities is very helpful.

Positively using contrarianism to purchase unpopular assets, on the other hand, is much trickier. Yes, the time to buy may be when the blood is in the street, as Baron Rothschild famously said, but sometimes the blood flows because the asset is deceased. For example, from Digital to Compaq to Wang to (I suspect) Research in Motion, the market is littered with the corpses of technology companies that were once regarded as good contrarian picks. The same has happened in many other industries, and other countries, and other types of securities.

The estimable Bill Bernstein puts the matter more pithily. After writing that contrarianism can be so unpopular a tactic as to have the word be "spat," he continues that it nevertheless can be profitable, with "the problem being the gap between expectoration and execution."

Oh, I wish that I had written that! But I will, Bill. I will. 

The Example of Closed-End Funds
One example of the gap between expectoration and execution lies with closed-end fund premiums. A week ago, The Wall Street Journal covered the slide in the prices of leveraged closed-end bond funds. When bond yields were low, such funds sold on average at a premium to their net asset values--that is, to purchase a CEF, investors were required to pay more than the value of the fund's underlying securities. Then as bonds declined in price and yields rose--which should have made bonds more attractive to buyers rather than less attractive (higher yields being a good thing, after all)--the premiums disappeared. Now those funds on average sell at a discount to their underlying values.

That's a pattern that seems easy to mine. If funds predictably sell at discounts when their underlying holdings are cheaper, and at premiums when their holdings are more expensive, then surely a profitable trading strategy can be devised. But the sheer number of funds, and the gradual and unpredictable nature of the movement from discount to premium (and then back to discount) confounds the effort. From what I can see, the best advice for owning CEFs falls well short of being a trading strategy. It is instead a simple guide:

1. That a fund sells at a discount is not reason enough for purchase.
2. That a fund sells at a premium is reason enough not to purchase.
3. If a fund purchased at a discount rises to trade at a premium, it likely should be sold, absent tax consequences or other reasons to postpone the trade.

Those three points could be extended to cover other assets as well. The investment approach of Just Say No is a mindset, not a formula.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.