Chidley... Time for investors to get greedy?
Markets offer big fish for contrarians
For contrarian investors, it’s an article of faith that the majority is often wrong, or at least wrong often enough that you can make some decent returns by betting against the herd.
Coming off a terrible few weeks in the markets, there’s little doubt right now that the herd is motivated by fear. Commodity prices remain depressed, driven down by the slackening Chinese economy. Meanwhile, faith in the U.S. economic recovery has been undermined by iffy jobs data, and by the Federal Reserve’s citing of turmoil in global markets as reason enough to delay raising interest rates in September.
There seems to be no end to the bad news. Last week, the International Monetary Fund (IMF) warned against a U.S. interest rate liftoff (not for the first time, by the way) in a report suggesting that a hike in rates could lead to a wave of defaults in emerging markets. The IMF’s Financial Stability Report estimates that corporate debt in emerging markets grew to more than US$18 trillion in 2014 from US$4 trillion in 2004, setting up a situation in which an uptick in lending rates could have disastrous consequences for the global banking system.
And don’t forget about the European refugee crisis, international head-butting over Ukraine, political instability in Turkey, and on and on.
By its very nature, contrarianism requires a healthy dose of courage, but the news is so bad out there these days it might well shake the faith of even the most dyed-in-the-wool contrarian.
Which, of course, is a contrarian signal.
So let’s say you’re a contrarian investor. What might prove you right?
First is U.S. interest rates. The markets seem to have completely priced out the prospect of an October liftoff, and more and more prognosticators doubt the Fed will hike rates at all this year. Among other factors, they cite last week’s U.S. employment data, which recorded job creation of just 142,000 for September. That was lower than analysts’ expectations by a long shot. And though the U.S. unemployment rate remained steady at 5.1 per cent, there’s little evidence that wages are seeing significant upticks.
These results were widely interpreted by markets as showing that the Fed won’t hike anytime soon, which as we saw this month — when stocks plunged after the Fed stood pat — doesn’t do any favours to stock valuations. But here, the markets could be wrong.
For one thing, the flattening out of job gains doesn’t necessarily mean the economy has stopped expanding. All it might mean is that the low interest rate environment has already done all it could to encourage employment gains. If the natural rate of unemployment is at or around five per cent anyway — where it seems to have stabilized in the past few months — then the Fed might conclude it is “mission accomplished” on jobs.
Think of it this way: If employment gains had been stronger and top-line unemployment had fallen below the five per cent mark, it would be a signal that perhaps the Fed had waited too long to raise rates and risked the economy getting overheated. Yellen and her crew might conclude that the September job numbers suggest that they have got it just about right, clearing the path for rate normalization.
So there is a case for a surprise from the Fed this year. If it’s the beginning of a careful, gradual return to more normal monetary policy, that will help put to rest lingering concerns about the health of the U.S. economy. It would also place Canada’s own economic rebound, so closely tied to U.S. for- tunes, on a firmer footing.
A contrarian play would be into sectors that benefit from higher interest, like financials. (Note the Dow Jones U.S. Financials Index is down more than nine per cent since mid-August.)
Then there’s the big fish for contrarians right now: emerging markets. Investors have been retreating from developing countries, selling US$40 billion in emerging markets assets in the third quarter — the biggest quarterly sell-off since 2008, according to the Institute of International Finance. The fears are being driven by concern over China, whose fallout would be hardest on Asian markets, and by EM corporate debt sensitivity to rising U.S. rates.
Are these fears overblown? On the debt concerns, a contrarian might point out that while corporate debt has indeed grown over the past decade, so too have the economies of emerging markets. GDP per capita in India and Thailand has more than doubled; in Brazil, Argentina and Indonesia, it’s tripled; in China, GDP has nearly quadrupled. Sure, low borrowing costs have helped, but all that money wasn’t lent just because it was cheap: it was also because of the growth prospects in emerging markets. Is a gradual rise in U.S. interest rates likely to derail that long-term trend?
Equity valuations in emerging markets have been plummeting, and a contrarian, who might also want to bet that fears of a hard landing for China are overblown, may be getting in the mood for bargain-hunting in places like India and European emerging markets.
Contrarians have their patron saint in no less a figure than Warren Buffett, who once famously wrote: “Be fearful when others are greedy. Be greedy when others are fearful.”
With so much anxiety in the markets these days, it might be time to get a little bit greedy.