short-term rates are pegged near zero, you flatten the yield curve – shrink the spread between short and long rates. We have more than 100 years of evidence confirming a wider spread is the real magic. Why? Think about bank lending. Short-term rates are banks’ funding costs. Long-term rates are their lending revenues. The difference – long rates minus short rates – mimics a bank’s gross operating profit margin.
Banks aren’t charities. They’re for-profit. The more profitable lending is, the more they’ll do it. The less profits, the less eager bankers are. They’ll sit on their hands. Just like they did all through QE. For years, the herd thought the Fed was the only thing propping up growth. In reality, the Fed killed lending and gave us the slowest loan growth in decades, almost no growth in the quantity of money (aka M4) – a point almost no one noticed – and the slowest gross domestic product (GDP) growth since World War II.
I explained all this to reporters, in vast detail with data. It made sense, they said! But they didn’t print it. If everyone said QE was a loose monetary policy, how could they publish some wacko saying it wasn’t? They couldn’t, because the wing nut part of the crowd would crucify them.
Major outlets wouldn’t, couldn’t print such a view on QE. In an age where seemingly every quoted expert, the Fed, the International Monetary Fund, the World Bank and every finance minister and central banker in the world said QE was a big economic lifeline and ending it was the biggest risk to the global economy, journalists would have to be out of their minds to differ. The commenters and bloggers would tear them to bits. It would be career suicide.
This makes it easier for real contrarians to sort through the media – there are always exceptions, but in general, it is pretty safe to assume that if headlines hype something, it isn’t a contrarian view. It won’t tell you anything you can act on. For that, you’ll have to venture off on your own.
The First Rule of True Contrarianism
Here is the fundamental feature of true contrarianism. If you don’t remember anything from the next nine chapters, remember this: If most believe something will happen in markets, the contrarian simply believes something else will.
This is what the curmudgeons mess up. Note, I didn’t say the opposite happens. Just something different. Markets price in to today’s prices what the crowds commonly conceive. If everyone is bearish because they see bad things, they might be right that they’re bad – but bad might not mean bearish! Because everyone sees the bad things, and they’re splashed all over the TV and Internet, they might be priced in. Those bad things might not matter at all. Or there could be some fundamentally big bad thing they aren’t seeing at all, and things end up worse than they expect!
This is what happened heading into 2008. Then, everyone said housing, subprime and toxic mortgage-backed securities were trouble. They would cause a recession and make stocks fall. So many said it! So many saw it!
No one, me included, saw an even bigger, quiet problem: November 2007’s implementation of the mark-to-market accounting rule (Statement of Financial Accounting Standards [FAS] 157, “Fair Value Measurements”), which could wipe a couple trillion dollars off bank balance sheets globally. No one fathomed that because every financial institution would have to mark every illiquid asset on its balance sheet at the going market price, whenever others sold a mortgage-backed security at fire-sale prices, everyone else would take a hit. Every bank in the US would have to take a paper loss on every comparable illiquid security it owned.
No one fathomed that this could cause pre-existing problems in subprime mortgages to eventually wipe out about
If it were just subprime and housing in 2008, we’d probably have just gotten a big correction. It wasn’t until around midyear, as the vicious circle of fire sales and write-downs picked up in earnest, that the real trauma started.
I missed it, too, which brings up the second big rule of contrarianism: You’ll be wrong sometimes. Contrarians know it, accept it. But you don’t have to be right all the time to do fine – a 60 % or 70 % success rate keeps you well ahead of most. As I’ve written in past books, if you’re right 70 % of the time in this realm, you become an absolute living legend. (Although it isn’t impossible that all the snarky new bloodsucking ensures no new living legends ever emerge and endure ever again. Of course, a contrarian won’t care about that – won’t care about self-image. Despite what you may have read of me from my many critics, I care little about my image. Neither should you.)
The All-Seeing Market
Contrarians know when not to move and where not to go. How? They know markets are mostly efficient. Not fully, perfectly efficient at every moment – otherwise there would be no opportunities! Contrarians realize markets can be quite irrational in the short term. But over time and on average, prices typically reflect all widely known information. If it’s out there, in the public domain, investors have already considered it and traded on it.
Rules, conventional wisdom and consensus expectations are all widely known. Ditto for ideological beliefs, biases and every “expert” view. Every textbook theory, rulebook and playbook ever published – markets know them inside and out. They know the rules, know the if-thens and know how most folks are likely to react to every news nugget. Markets know what the crowd will do before the people themselves know.
The same is true for seasonal myths and technical indicators. Dow Theory is perhaps the most extreme example. This indicator, around since the late nineteenth century, says that when the Dow Transports and Industrials hit new highs together, you get a lasting bull trend. If they hit new lows together, look out below. There is also a lot of mumbo-jumbo in between, but I’ll spare you – the extremes are what matter. If Dow Theory were right, no bull market would ever end because the signal would keep on signaling, and stocks would keep on rising! Same in a bear market. But cycles always turn! Markets have priced all those Dow Theory expectations, and they’ll ultimately do something different.
Different, Not Opposite
Whatever the rules say and the herd expects, you can bet the markets won’t do. But that doesn’t mean the opposite outcome happens!
Think back to our clock analogy. If everyone expects the hand to land on 1, the curmudgeon bets close to 7. The real contrarians remember markets are efficient, so they know the clock probably won’t land between about 11 and 3 – it would be too near where most folks expect. The contrarian can effectively rule out four possibilities. But there are still eight hours’ worth of potential outcomes.
For example, if most expect stocks to rise 10 % in a year, true contrarians bet stocks probably won’t land in the 5 % to 15 % range. But that still leaves a big up year, flat returns or down.
Understanding how markets discount known information helps you narrow the range of possibilities. It doesn’t tell you what will happen – that’s where curmudgeons get messed up – it just tells you what probably won’t happen and frees you to contemplate what might happen and improve your odds.
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