Wednesday, August 5, 2009

Futia, The Art of Contrarian Trading

The first part of Carl Futia’s The Art of Contrarian Trading: How to Profit from Crowd Behavior in the Financial Markets (Wiley, 2009) is quasi-theoretical; it is a well researched, tightly written analysis of investment crowds. The second part is practical—how to make money being a contrarian. Since I’ve always been more attracted to the “why” than to the “how,” it’s no surprise that I found the first part of the book more compelling than the second.

Futia makes his case for contrarian trading by appealing to the “No Free Lunch principle.” As applied to investing, it means that nothing that is widely known—fundamental, technical, or statistical—will give the speculator an edge and help him beat the market. It also means that there is no financial edge in joining an investment crowd, however comfortable and socially rewarding such membership may be. In fact, “it is his ability to suffer the internal conflicts and the social isolation associated with a contrarian investment stance that is the source of a contrarian trader’s edge.” (p. 29)

Futia criticizes market timing, pointing out that even if the market timer is highly skilled and is correct 70% of the time, he has to be right twice in a row; the probability of this happening is 70% x 70%, or 49%. Yet the contrarian is by definition a market timer even if he uses different tools from the technician. “His business is exploiting market mistakes arising from the growth of an investment crowd but then stepping aside from his investment as the life cycle of the crowd inevitably returns price to fair value.” (p. 28)

The one deadly mistake a contrarian can make that will lead to underperformance of the buy-and-hold strategy is to be out of or short the market when it is rising. And yet novice contrarians tend to commit this very mistake. Futia suggests that since it is much more difficult to ascertain when the market is overvalued than when it is undervalued, the novice should focus his attention on periods of undervaluation.

How does the contrarian go about figuring out market mistakes? Futia relies mainly on his media diary (including magazine covers and headlines), secondarily on the distance of the S&P 500 from its 50 and 200 day moving averages. He offers strategies for both conservative and aggressive contrarians using mostly broad market ETFs.

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