THE BLOG
06/08/2010 05:12 am ET | Updated May 25, 2011

Why Contrarianism Works

In just over a year, the Dow has recovered to 10,881, from 6,547. The biggest rally of our lifetimes has lifted markets nearly 70%. Paradoxically, now's time to be more cautious, while a year ago was the time for optimism. Why was optimism warranted when the world was falling apart? Why is caution more appropriate now? The answer lies in the nature of markets.

To go against the grain of anything is, well, counterintuitive.

Our lives glide most easily on the broad wings of intuition. The most human elements of our lives--love, family, and friendship--are intuitive and instinctive. There's not much purpose in contradicting the natural. We are, after all, not as distant as we would like from our Neanderthal ancestors: 45,000 years is a blink of evolution's eye. For a cave dweller to ignore instinct was fatal.

But the financial markets reverse this natural order of things. In an ecosystem where prices reflect instinctive thought, no one can outsmart the system by reacting to such thought. Put another way, the markets price in all consensus emotion by the tick. If you are panicked, others are too, and their mood has already set the current price level. If you are euphoric about world events, so are your neighbors. Prices already reflect their optimism. The stock market is like an auction by millisecond: bids are instantaneous and prices immediately reflect human emotion. Prices do not wait for emotion; they are literally defined by it. The sheer number of participants and trades ensures relatively efficient pricing, where the market sops up human greed and fear as soon as it exists.

Behavioral finance tells us that markets are psychological thermometers, taking our mass temperature and distilling the result into one number, say Dow 6,500 or Dow 11,000.
The market looks at fundamentals, such as earnings, cash flows and interest rates and then applies an average price to them. But whether that price is high or low depends on our collective mood.

Since markets price in current emotion, it follows that the only way to beat the market is to go against it--that is, buy when others are selling and sell when others are buying. As Warren Buffett says, "Be greedy when others are fearful and fearful when others are greedy."

The ability of the contrarian to take advantage of conventional wisdom, and not get swept away by it, explains the success of the counter-intuitive investor. All great value investors operate in contrarian fashion, buying counter-intuitively what others have intuitively discarded. When Buffett bought Goldman Sachs or Chris Davis (of the Clipper Fund and the Davis Financial Fund) bought Amex on the cheap a year ago, they bought what no one else wanted to own. Those stocks have more than doubled since.

Just over a year ago, we made the case for equities, even as no one wanted to hear it: Reports of the Death of Equities: Greatly Exaggerated

The market is now approaching fair value. The normalized free cash flow (FCF) yield on the S&P 500 is no longer the juicy 12% that it was a year ago. But markets are not yet too expensive. By our estimate, FCF yields are still a respectable 7%. A yield under 4% would define overpriced.

When giddy optimism returns, and the champagne once again tastes as good as it did in 1999, and the world shouts buy with one clear voice, it will be time to sell some stock.