On Contrarianism

I wrote the following on December 23rd, 2009:

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With markets, it doesn’t matter what people say. What matters is what they rely upon.

Face it, people have opinions, and when asked only the most cautious or prudent won’t give an answer. Talk is cheap.

But money talks. What will people or institutions risk some of their financial well-being in order to make money?

Turning points are exceptionally difficult to call with time precision. Anyone can say that a trend is going to break for a long while before it breaks; the trick is to be able to make the change within a short distance of the inflection point. I’ve done it a few times, but I have little confidence in whether I can do it regularly.

Examples:

• Five months before the crest of the housing bubble, I wrote a piece on why it would pop soon.
• A few months before the subprime mortgage crisis hit, I wrote a piece on why it would end badly.
• In March of 2000, I told the investment department that I worked in that financing for tech companies was unwinding, and that the tech bubble would deflate.
• In October 2002, I sensed that the bear market was over and began taking risk in my own portfolio, as well as my main client’s portfolio.
• In May 2003, I told my boss that we were in a liquidity rally and that shorting lower grade companies was suicidal, because financing was becoming available for marginal ideas. In early 2004, I confirmed that by writing a piece showing that the bull market had a way to go.
• And recently, I made predictions on munis, mortgage bonds, agency bonds, and investment grade and junk corporates.

Now part of this is that if you predict enough things, you will have some right ones to point to. I am obviously picking and choosing here, but when I made these predictions, there was a method to my madness. I am not like Cramer, who makes predictions every day. I wait for points where markets are out of kilter, and then I act, and sometimes predict.

Calling turning points is very difficult. I want to offer two bits of advice to those to try to do so.

1) Look for situations where the yield is unsustainable on the high side or on the low side.

Examples:

• Earnings yield too low during the tech bubble. Also workers were relying on stock to rise, because they were getting much of their pay through options.
• Net yield on much residential investment real estate negative in 2005-7, without even factoring in maintenance costs. When someone is relying on price appreciation in order to break even something is wrong.
• Toward the end of the commercial real estate bubble, the same was true. Equity investors began to rely on price appreciation in order to break even.
• When spreads on high yield blew out, at its worst the market was assuming that half of all high yield issues would die, with low recoveries. Even the Great Depression wasn’t that bad. The same was true in a faint echo for BBB Corporates.
• During the recent bottom in March 2009, high quality companies could be bought for less than their net worth and at earnings yields unseen since 1973-74.

2) Look for a qualitative change when you think we might be near a turning point.

• Chatter changes at/near turning points. Certainty gives way to uncertainty. Uncertainty gives way to worry. Worry gives way to panic. In October 2005, Googlebots that I created tipped me off to the change in the residential real estate markets way ahead of most parties.
• Inflection points tend to be times of stasis as far as economic variables go, but confusion in terms of chatter. During the tech bubble in early 2000, the chatter became decidedly less certain.

Inflection points are times of change, and chatter should reflect that.

Coming back to contrarianism, ask yourself, “What are people relying on to be true, that may not be true?” That is what it means to be a contrarian. Mere disagreement means little. Where have men placed their bets? Betting against the consensus is what a contrarian does.

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You want to be a contrarian now? Really? How about the coal industry? What, you say that it’s no good because of cheap natural gas prices? No reason to burn coal, when natural gas is cheap enough to burn as baseload. But what of the future? Will natural gas always be so cheap? It might, in which case one relegates coal for energy to the “buggy whip” category for some time.

But it might not. Frackers may get more selective as output prices fall, and demand may return for coal. Regardless, it will take time for coal to regain pricing power, and many coal companies may go broke while waiting. There is only one coal company with no debt on it:

Hallador Energy Company, formerly Hallador Petroleum Company is engaged in the production of steam coal from a shallow underground mine located in western Indiana. The wholly owned subsidiary of the Company is Sunrise Coal, LLC (Sunrise). As of December 31, 2009, the Company owns a 45% equity interest in Savoy Energy L.P., private company which has operations in Michigan. The primary operating property of the Company is the Carlisle underground coal mine located in western Indiana.

HNRG is the ticker… an oddball small cap, but more likely to survive than many larger firms.