Are You A Contrarian Or An Idiot?

Are you a contrarian or are you an idiot? Most that claim to be the former are actually the latter.

I’m not sure why so many think that being a contrarian means that you have to fight every trend all of the time but the reality is that a successful contrarian picks their spots.  This is because most of the time the prevailing trend is the correct one and even if it is not it usually outlasts your ability to fight it. The end result is that you lose most, or all, of your money by fighting it. I don’t know about you but this has never made much sense to me.  On the other hand always going with the trend, while ensuring that you are in major moves, also means that you miss a lot of fantastic risk reward situations. Of course I have never claimed to be a contrarian or a trend follower, instead I just try and find trades with good risk and reward characteristics.

Part of my process at The Macro Trader includes a series of questions as well as a model that I have to go through before I can put on a trade. The first question is “What is the trend?” The reason being that unless my reason to go against the trend is very strong…….I should not be putting it on. Another way of saying this is I believe in going with the trend except for when I totally do not. Medium term counter trend trading, being a contrarian, is only really appropriate when you truly have a variant view on what the market should be doing and NOT when you have one or two data points that are contra to what the market is already doing.

One classic example is when you see a stock that is trading at what you think is a clearly unsustainable valuation. Is the P/E ratio really your only reason to want to short the stock? If so you might want to revisit history as it is replete with overvalued companies that got far more overvalued, or that grew our of their overvaluation and never crashed. Using this example you would want to find reasons why this valuations were not just high but unsustainable because sales were declining, debt costs were overwhelming, the sector was falling apart, and the stock was making a topping pattern.  When the weight of the evidence is pointing to a change in trend both fundamentally and technically then it might be a great time to go against it, not when you see one data point that seems out of whack.

Another example, and one more specific and current, is that of the yield curve. If you look at the 5-30 curve in the chart below you can see that it has been consolidating for the past two and a half months. The stubborn contrarian would say that it has bottomed and they would want to buy it as they now expect the curve to steepen.

Yield Curve 5-30 .4

Is the stubborn contrarian asking the right question here? For that matter is the stubborn contrarian asking any question here? Technically this chart shows that the 5-30 curve is in a downtrend and while it has consolidated a bit it has yet to make a higher high. Nothing in the chart is indicating the trend has changed but instead that the trend has slowed down and consolidated.

Instead we would hope that you ask yourself what is your fundamental view of the direction of the curve? Is the Fed going to hike rates in the coming months or not? What is going to happen to the 5-Yr and what is going to happen to the 30-Yr? What is consensus on this trade? How right or wrong is consensus? What is the risk/reward in either direction? And other questions like this. If you then find that your view is far enough away from consensus and that the risk/reward is good enough maybe you do go long a steepener on a breakout of the consolidation. If on the other hand you find that your view is barely out of consensus you might want to rethink your idea as more often than not the prevailing trend is correct.

Another way of looking at this that is purely technical could be to define what constitutes a change in trend. Maybe a breakout above the downward trendline as well as above the consolidation would constitute a change in trend using your rules. If so, a break in the chart below might be sufficient for you to go against the previous trend. If on the other hand you claim to only trade when the technicals match up with your fundamental view then you better actually think that the yield curve is going to be steeper in medium term than it currently is.

Yield Curve 5-30 .5

Notice how so far we have not made a judgement call on what our view of the yield curve is. Instead we have simply tried to walk you through the thought process of going against this downtrend. As discretionary global macro traders we require a strong reason as well as a good chart to get us into any trade. When it comes to going against the prevailing trend we require a lot more as we are saying that we are smarter than the market and by extension the majority of its participants.

All of this has been a long winded way of saying that going against the trend for the sake of being different is stupid. Make sure that you are being objective and that your contrarian view is both your actual view and that it is differentiated enough that it makes sense to go against the prevailing trend. Doing otherwise makes you not so much a contrarian but an idiot.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

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