Contrarian Trading & Investment Strategies
Contrarian trading and investment strategies involve going against prevailing market trends or sentiments.
This approach is based on the belief that markets often overreact to news and create mispriced securities.
Contrarian investors seek to capitalize on these inefficiencies.
Key Takeaways – Contrarian Trading & Investment Strategies
- Contrarian trading and investment strategies involve going against prevailing market trends.
- Examples: Buying undervalued assets and selling overvalued assets. Trimming stock allocations as stocks rise and increasing them when stocks fall.
- Often relies on fundamental analysis to gauge true asset value.
- An institutional investor, in general, is more likely to view assets that went up in terms of being more expensive and having a compressed risk premium.
- A retail trader, on the other hand, tends to think more in terms of what went up as being better and extrapolate that forward.
Theory Behind Contrarian Strategies
Contrarian strategies are often viewed in the context of behavioral finance, which examines how psychological influences and biases affect the financial behaviors of traders/investors and markets.
Key principles include:
Overreaction and Correction
Markets often overreact to news, both good and bad, leading to asset mispricing.
Mean Reversion
Over time, some prices tend to return to their historical averages.
This is more common for certain types of commodities (when inflation-adjusted) and interest rates.
They tend to go through cycles but without drift (unlike equities).
For example, oil tends to not be too high or too low for long.
Interest rates also tend to not stay too high or too low forever.
Many quantitative models are based on mean-reverting behavior (e.g., Vasicek model for interest rates).
Herd Behavior
Many traders follow market trends and are momentum-driven, creating opportunities for contrarians when these trends reverse.
For example, people will tend to buy things when they go up in price (which often means they’re more expensive) when the opposite is generally the better approach.
Identifying Contrarian Opportunities
Contrarians often use sentiment indicators to gauge whether an asset is overbought (overly popular) or oversold (unjustifiably ignored).
These indicators include:
Put-Call Ratio
High values for this indicator may indicate a bearish market sentiment.
This is a potential buy signal for contrarians.
Short Interest
A high level of short interest might suggest that a stock is ripe for a rebound.
News and Analyst Ratings
Pessimistic news or analyst downgrades can sometimes signal a contrarian buy opportunity.
Fundamental Analysis
Contrarians perform in-depth fundamental analysis to identify undervalued or overvalued assets.
This involves examining:
Financial Health
Analyzing balance sheets, income statements, and cash flow statements.
Valuation Metrics
Evaluating price-to-earnings ratios, book values, and other valuation measures and financial metrics.
Let’s look at some of the most popular contrarian strategies.
Popular Contrarian Strategies
Value Investing
Value investing is a contrarian strategy that involves identifying and investing in undervalued stocks.
This approach, popularized by Benjamin Graham and Warren Buffett, focuses on finding companies with strong fundamentals trading below their intrinsic value.
This can be applied to various financial pursuits, whether it’s liquid markets and day trading, private markets/real estate, consumption, etc.
For day traders, value-based considerations are less important because it can take time to play out, but for those with a hybrid approach to trading (i.e., trading on various timeframes), value considerations can certainly be part of it.
Reverse ETF Investing
This strategy involves investing in exchange-traded funds (ETFs) that are designed to perform inversely to their underlying index or asset.
When a particular market or sector is experiencing a downturn, a contrarian trade might put money into reverse ETFs to profit from the decline.
Crisis Investing
This approach involves trading assets or markets during times of economic, political, or social turmoil.
Contrarian investors might see opportunities in distressed assets or economies that others are avoiding due to perceived risks (covered more below).
This could also include underinvested markets.
Pairs Trading
Pairs trading is a market-neutral strategy where a trader goes long on one security while simultaneously shorting a related security.
This approach can be considered contrarian as it often involves betting against the relative performance of two correlated assets.
It’s popularly called relative value.
Dividend Growth Investing in Non-Trending Sectors
This strategy focuses on identifying companies with consistent dividend growth in sectors that are currently out of favor with the broader market.
It combines the contrarian approach of investing in unpopular sectors with the stability of dividend-paying stocks.
This can also include certain sectors that some market participants avoid, which can compress their valuations – e.g., tobacco, alcohol, oil.
Emerging Market Value Investing
This involves applying value investing principles to emerging markets, which are often overlooked or misunderstood by the broader investment community.
Contrarian investors might find opportunities in countries or regions that are temporarily out of favor.
Emerging markets are often misunderstood or underinvested due to factors like capital controls, political instability, currency risks, and unfamiliar cultural or business practices.
These regions may have complex regulatory environments or opaque financial reporting, which can deter investors.
It may have a different political system.
Additionally, temporary economic downturns or geopolitical tensions can cause markets to fall out of favor.
Emerging markets can also be subject to “hot money” flows.
Contrarian investors see these as opportunities, betting on the long-term potential of undervalued assets in economies with room for significant growth.
Distressed Securities
Distressed securities investing is a contrarian strategy that involves buying the stocks or bonds of companies in financial distress, often trading at significant discounts due to bankruptcy fears or other financial troubles.
This approach requires a deep understanding of corporate finance, bankruptcy laws, and industry dynamics.
Contrarian investors in this space believe that the market often overreacts to negative news.
In turn, this creates opportunities to purchase assets at prices below their intrinsic value.
The strategy involves:
- Identifying companies with fixable problems
- Analyzing debt covenants and capital structures
- Estimating recovery values in various scenarios
- Participating in bankruptcy proceedings if necessary (e.g., workouts, restructuring)
While risky, successful distressed investing can yield substantial returns if the company recovers or if the investor can influence the restructuring process to their advantage.
Contrarian Sector Rotation
This strategy is an active trading approach that involves investing in out-of-favor sectors while reducing exposure to popular ones.
It’s based on the principle that different sectors of the economy perform well at different times, and that excessive optimism or pessimism can lead to mispricing.
Contrarian sector rotation might involve:
- Identifying sectors with persistently low valuations
- Analyzing sector-specific economic indicators
- Monitoring institutional ownership trends
- Investing in sector-specific ETFs or a basket of individual stocks
For example, when technology stocks are booming, a contrarian investor might reduce tech exposure and increase allocation to unfashionable sectors like utilities or consumer staples.
Merger Arbitrage
While not always considered contrarian, merger arbitrage can be a contrarian play in certain situations.
This strategy involves profiting from the price discrepancies that often exist between the trading price of a target company and the price an acquirer has agreed to pay.
Contrarian aspects of merger arbitrage include:
- Betting on deals that the market believes are likely to fail
- Taking positions in complex transactions that other investors find difficult to analyze
- Investing in deals involving unpopular companies or sectors
Successful merger arbitrage requires a deep understanding of regulatory processes, antitrust laws, and deal structures.
Individual traders can also participate in merger arbitrage by buying/shorting the public securities involved.
Contrarian Forex Trading
In the foreign exchange market, contrarian traders look for opportunities to trade against prevailing currency trends.
This can involve:
- Identifying overbought or oversold currencies using whatever criteria they prefer (e.g., technical indicators, macro-focused fundamentals)
- Analyzing economic fundamentals that might contradict current trends
- Taking positions opposite to the majority of retail traders
- Exploiting situations where central bank policies diverge from market expectations
For example, a contrarian currency trader might buy a currency that has been heavily sold off due to political instability, believing that the market has overreacted to short-term news.
This could even mean comments that are misinterpreted by the public, such as the belief a leader prefers a weaker currency (i.e., to boost exports) when they were misconstrued and simply want a fairly valued currency.
Long-Term Option Strategies
Contrarian investors can use options to express their views, often focusing on longer-dated contracts that other investors might overlook.
Strategies might include:
- Selling overpriced long-term put options on quality companies during market panics
- Selling options on securities they’d like to buy at a certain price
- Buying long-dated call options on out-of-favor stocks or sectors
- Using calendar spreads that benefit from a reversion to historical volatility levels
- Using ratio spreads to profit from a contrarian view while limiting risk
These strategies allow investors to gain leveraged exposure to contrarian ideas while often benefiting from the time decay of options.
Contrarian Real Estate Investing
Real estate markets can be cyclical and prone to boom-bust dynamics, creating opportunities for contrarian investors.
This strategy might involve:
- Investing in areas experiencing temporary economic difficulties
- Purchasing properties in neighborhoods on the cusp of gentrification
- Focusing on property types that are out of favor (e.g., office space during a work-from-home trend)
- Developing land in areas that are currently unpopular but have long-term potential
Successful contrarian real estate investing often requires patience and the ability to weather short-term market fluctuations.
Activist Short Selling
While short selling is inherently contrarian, activist short selling takes this a step further.
Activist short sellers not only bet against overvalued companies but also publicly campaign to expose what they believe are fraudulent, using misleading business practices, or following poor business models.
This strategy involves:
- Conducting in-depth research to identify potential fraud or overvaluation
- Identifying poor business models
- Publishing detailed reports outlining the bear case for a stock
- Engaging with regulators or law enforcement when fraud is suspected
- Managing reputational risks, security, and potential legal challenges
Activist short selling is controversial and risky, but it can be highly profitable and serve a market-cleansing function when done responsibly.
It can also expose bad actors and financial promotions.
Contrarian Thematic Investing
This approach involves identifying and investing in long-term themes that are currently unpopular or overlooked by the market.
Examples might include:
- Investing in clean coal technology when renewable energy is in vogue
- Backing nuclear energy companies during periods of anti-nuclear sentiment
- Investing in physical retail and brick-and-mortar concepts during the e-commerce boom
- Supporting traditional media companies and newspapers adapting to the digital age
- Owning tobacco companies when tobacco usage has consistently fallen over time
Successful contrarian thematic investing requires a long-term perspective and the ability to distinguish between truly obsolete business models and those that are merely out of favor – or simply don’t have a lot of capital going after them due to poor marketing, negative publicity, or other reasons.
For example, these types of traders/investors recognize that:
- Physical stores and malls will never be truly obsolete.
- Print media will continue to be a thing,
- People will still consume things that may not necessarily be the most healthful.
- Oil and gas companies may still thrive despite more of a shift toward green energy, as energy demand remains strong in many sectors.
- Legacy automakers could rebound as they help satisfy EV demand and develop new technologies like advancements in hybrid drivetrains and traditional internal combustion.
- Precious metals, like gold or silver, may regain prominence as currency hedges, despite the relatively recent popularity of cryptocurrencies.
- Traditional agriculture and farming will still be popular despite hype around lab-grown alternatives or synthetic foods.
Overall, it’s about analysis, a logical understanding of what’s likely to transpire, and understanding that money and credit flows in markets are often influenced by narrative and biases.
Tail Risk Hedging
While not a pure contrarian strategy, tail risk hedging can be seen as contrarian in that it involves allocating capital to strategies that lose money most of the time but pay off significantly during rare, extreme events.
This might involve:
- Purchasing out-of-the-money put options on broad market indices
- Owning volatility instruments that spike during market falls
- Maintaining positions in safe-haven assets like gold or certain currencies that can protect against currency devaluation
- Using complex derivatives strategies to create convex payoff profiles
Tail risk hedging can be seen as contrarian because it involves consistently paying for insurance that the market often undervalues.
Contrarian ESG Investing
As ESG becomes mainstream, contrarian opportunities may arise.
This could involve:
- Investing in “sin stocks” that are excluded from ESG indices and being dropped by certain institutions due to external pressure (e.g., university foundations, sovereign wealth funds) but have strong financials
- Alcohol, tobacco, and oil and gas are popular examples
- Identifying companies making genuine ESG improvements that aren’t yet recognized by the market
- Seeking opportunities in industries necessary for the energy transition but currently out of favor (e.g., certain mining companies)
- Companies developing innovative solutions to ESG challenges that are currently overlooked
- Companies currently pursuing approaches that are deemed uneconomic, but could be good businesses in time due to economies of scale (fixed costs are less onerous as the business grows), or technological or other improvements
This approach requires balancing ethical considerations with financial opportunities and a nuanced understanding of ESG trends.
Risks and Challenges
Timing
Entering a position too early can lead to significant losses if the market continues to move against the contrarian view.
Persistence of Trends
Contrarian strategies can be risky during strong, persistent market trends.
Betting against a strong uptrend or downtrend can lead to losses if the trend continues longer than anticipated.
And, for example, if a company is earning more over time, then an upward trend in its stock price could be entirely justified.
Market Efficiency
In efficient markets, finding mispriced assets is more challenging, and the opportunities for contrarian gains are reduced.
Implementing Contrarian Strategies
Portfolio Diversification
Contrarians should diversify their investments to mitigate risks.
This involves spreading investments across various sectors, asset classes, and geographical regions.
Risk Management
Risk management – e.g., diversification, options to limit tail risk – helps limit losses if the market moves against the contrarian position.
Patience and Discipline
Contrarian investing requires a patient and disciplined approach.
It often involves going against prevailing market sentiments and waiting for the market to recognize an asset’s true value.
For long-duration asset classes in particular (e.g., equities) this can take a very long time.
What Type of Market Participants Are Contrarians (and Not Contrarians)?
The distinction between “contrarian” and other investment approaches, such as momentum-driven strategies, often depends on the:
- investment horizon
- risk tolerance, and
- primary objectives of the market participants
Pension Funds – Inherently Contrarian Due to Allocation Mandates
Pension funds – as well as endowments, foundations, and sovereign wealth funds – typically have long-term investment horizons and are driven by the need to manage risks while ensuring steady returns over decades.
This long-term perspective aligns with a more contrarian approach.
Their investment strategies often involve maintaining a specific asset allocation that balances stocks, bonds, and other asset classes according to predefined mandates.
When a particular asset class outperforms and becomes a larger portion of the portfolio than intended, pension funds may sell portions of it (despite its recent success) to rebalance back to the target allocation.
Similarly, they might buy more of an underperforming asset class to maintain the balance.
This rebalancing is contrarian in nature as it involves selling assets that have appreciated (against the prevailing bullish trend) and buying assets that have depreciated (against the prevailing bearish trend).
Retail Traders – Tendency Towards Momentum Trading
Retail traders, in contrast, often have shorter investment horizons and may be more focused on capitalizing on current market trends.
Many retail traders engage in momentum trading.
This means buying assets that have been performing well in the expectation that their upward price movement will continue.
Conversely, they might sell or avoid assets that are currently on a downtrend.
Basically an overall tendency to hop on whatever is “hot.”
This approach is less about seeking value in underpriced assets and more about riding the waves of market sentiment and trends.
Retail traders may be more reactive to recent market news and trends.
This makes their approach more aligned with momentum strategies rather than contrarian strategies.
Institutional traders often engage in momentum trading as well, but it’s generally done as an algorithmic strategy.
Example: US Markets vs. Chinese Markets
US markets are heavily influenced by institutional investors like pension funds and hedge funds, which often adopt a contrarian approach.
They (categorically) tend to focus on long-term value and rebalancing strategies.
In contrast, some Asian markets, notably China’s, are characterized by a stronger retail investor presence.
Retail traders typically engage in momentum trading, reacting quickly to market trends and news.
This tends to drive more short-term, trend-based market movements.
This distinction in investor composition leads to a more contrarian-driven market in the US and a momentum-driven market in parts of Asia.
A Matter of Philosophy
The fundamental difference lies in the investment philosophy:
- contrarian investors like pension funds seek value in underpriced assets and are willing to go against the market sentiment, while
- momentum traders, including many retail traders, follow the current trends, seeking profits from continuing movements in the market’s direction
The contrarian approach requires an understanding of market fundamentals and cycles, along with a high level of discipline and patience, as it often involves going against prevailing market sentiment and waiting for the market to recognize the true value of the underpriced assets.
In contrast, momentum trading is more about capitalizing on the market’s current trajectory.
How Can I Become More Contrarian in My Approach?
The simplest method to adopt a contrarian approach is to periodically rebalance your portfolio.
This helps align it with your target asset allocation.
At the same time, carefully consider transaction costs and tax implications.
Related