Playing QE up and down proves contrarians win some of


I’m always delighted to give a wider audience to the product of excellent thought processes. Like this article from Roy Topol, a gent who predicted the demise of 1Time while the shares were still surging. Here he offers a rational analysis of what to expect during the next leg in the Quantitative Easing saga.

By Roy Topol*

While there are two “scientific” forms of investing – growth and value investing – we can also refer to two main psychological frame points that investors use to make decisions – contrarian and herd-mentality.

The two sets are often confused and perhaps justifiably so – growth shares tend to go up ahead of markets and outperform in bull markets when markets are pushing them to extreme valuations; while value shares tend to lag the market and underperform in bull markets. Therefore, by and large, many growth investors tend to fit into the same camp as the herd, while value investors are often contrarian in nature.

But who is right and which way is the best way to invest? Is the herd right or do those with contrarian mindsets win the game of investing? And, most importantly, what do we do now?

There is evidence that value shares outperform growth shares in the long-term and therefore value investing should be the way to go for long-term investors. But there are also many opportunities where the contrarians gain significant outperformance by betting against the market in the short-term – recent stock market highs and lows in 2000, 2003, 2007 and 2009 come to mind.

The problem with investing is that if you stick yourself in either camp, you will have periods of huge pain and underperformance and be wrong for a long time. So perhaps the answer to the question is not to align oneself with either camp, but perhaps rather to be agile – swim with the current when it is calm, but get out the ocean when the current becomes too strong. Or, to put it another way, do the exact opposite of the herd (ie. get out of the way!) when the herd is in full charge.

Which of course is easier said than done. It’s easy to look back at history and explain what happened and why. As Warren Buffett says: “In the business world, the rear-view mirror is always clearer than the windshield.” Explaining the past is easy. Predicting the future is impossible. So how should we go about investing? And after a four year bull market where most assets prices have doubled, what should we do now?

Perhaps we should look at what caused the previous crisis, what the solution to the crisis has been, and what this all means for asset prices. The previous financial crisis was averted when the Fed started its quantitative easing (QE) programme, by which it bought trillions of dollars of Treasuries in the market, thereby providing much needed liquidity which has propelled the market upwards to recent levels. But when Ben Bernanke stood up to answer questions after giving testimony before Congress on 22 May, he alluded to the possibility that the tapering of QE may happen in the upcoming FOMC meetings, sending markets into a flat spin. Bond markets and equity markets, which were near or at record highs, fell drastically, causing rippling effects for all asset prices around the world. Bonds, equities, currency and commodities went haywire. Markets recovered somewhat in the following weeks, but on 19 June at the next FOMC meeting Bernanke gave details about the tapering of QE – the Fed would start to taper when unemployment hits 7% and this was predicted to happen at the beginning of 2014. Markets went into freefall. The message was clear – the world of cheap and easy money was coming to an end.

And cheap money there has been. 10 year US government bond yields below 1.5% had never been seen before. The one thing QE has done, in addition to providing liquidity, is create incredible leverage in the system: from record high leverage on the New York Stock Exchange, to a herd of carry trade investors borrowing cheaply in developed markets to invest in higher yielding emerging market bonds. The herd was at full tilt.

So maybe we are (or just were) at one of those extreme periods where the contrarians win. Not extreme equity valuations perhaps, but maybe an extreme in financial leverage? With the cost of money increasing at a dramatic rate (bond yields rising drastically), could this financial leverage be a problem in itself? Whatever the case may be, the herd is in full stampede and is highly leveraged.

If we do sell equities, the next problem comes in deciding what to do with the proceeds. Bonds seem overvalued. Cash gives you a poor nominal return and negative real return. Even low beta, high dividend paying shares (a popular and perhaps overcrowded trade) seem overvalued. Historically, you could switch out of equities into bonds to ride out the cycle, but presently that switch doesn’t look too wise. So while there is excessive leverage in the system, at the same time, if you sell your equities and don’t want to buy bonds, what do you do now?

This period that we are in is perhaps one of the most difficult times to make asset allocations decisions. But maybe this is the time where the contrarians come out and show that they are truly ahead of the herd.

*Roy Topol and I have corresponded regularly over the years. I’m a fan of his views. His day job is an investment manager at Investec Wealth & Investment.

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