Investment Idea

Avoid contrarian thinking: brace yourself for the recession and buy only cheap stocks

Mikael Syding
09/01/2023 | 6 min read

Avoid contrarian thinking: don’t dismiss the coming recession, focus on cheap stocks. It is impossible to know what "everyone" thinks in the financial market. Otherwise, it would be much easier to invest. It's just doing the opposite of what everyone has already positioned themselves for. For example, if everyone is really positive and thus has bought with all the money they have, then there are no buyers left and the only way is down. It is of course possible to nuance the statement that many are positive (have bought) rather than exactly all, but the idea is still that the conclusion should be the same: sell when there is positive sentiment and buy when it is negative.

An alternative way of expressing the same contrarian hypothesis about the functioning of the market is the statement "When everyone expects something, it doesn't happen". A current example concerns whether there will be a recession in 2023 or not, and if so, when it will occur. In particular, this applies if the stock market will react negatively to a recession that is expected. Quite a few seem to have the attitude that a recession is both planned (by central banks such as the Fed), desired (to prevent inflation from taking hold) and so expected that stock markets will rise when recession headlines mean that black ink risks becoming a scarce commodity on a level with natural gas ( or "fossil gas" which now seems to be the official term after 12 years of lobbying by the Nature Conservation Society).

"Contrary analysis", thinking that an outcome in a complex and reflexive context will be the opposite of what one's logical reasoning and intuition arrive at, is a classic financial sport. "Good news is bad news now" is sometimes said, when more than expected jobs lead to a stock market crash due to concerns that increased growth will reveal bottlenecks in the economy that lead to inflation and higher interest rates. A really weak company report can result in a higher share price at the end of the day due to "shorters taking the opportunity to cover their positions". That's how you can go on all day with anti-thinking and second guessing of yourself, of others, of logical reasoning and sound fundamental investment grounds. In the long run, it is probably better to understand what actually drives the values and prices of assets and invest long-term with a substantial margin of safety to your return requirement. If you require at least 10% a year to be satisfied with your investment in time, deferred consumption, stress, etc., then never invest in something you don't calculate should give at least 15%.

There is a truth in the reverse analysis, as there always is in the opposite of every profound truth. It clearly sometimes works to follow it - that is, to do the opposite of what seems reasonable. Furthermore, the theory itself is crystal clear. If everyone has bought, there are no buyers left. If the recession is completely expected then everyone has already factored in their earnings forecasts, valuation multiples and stock prices so that the only way forward is up. However, that is not the only "truth" about contrarian investment principles. A more important insight is that the reverse analysis points to the fact that we do not understand what is going on, that we cannot predict all other people's thoughts and behavior. Not least, it reveals that sentiment surveys fail to capture how the investor collective is actually positioned or has the potential to trade for, regardless of whether the surveys are systematic or anecdotal with data all the way down to n=1. So, when someone claims that everyone has bought, or that there is a lot of money on the sidelines, or that everyone and his mom plus her dog is expecting a recession and stock market crash in the first half of 2023, you shouldn't automatically assume that just that is out of the question.

It could still both be a decline in H1 2023 or not be a decline then, and it usually has very little to do with the very information that yet another pundit in the market happens to report right now. It applies to me, it applies to financial TV profiles, fine tweeters, analysts and so-called strategists and macroeconomists. Sure, some have had a slightly better track record than others, but in the long run no one is systematically right in such a sufficiently deviant way that it can be used. Or, well, some may have, but it's hard to know which ones. It is probably harder to identify good oracles than just doing your own analysis of what are good fundamental investments and what are not. Then you know in any case what kind of analysis you have done and can adapt to changed conditions.

I myself am of course influenced by all the information that finds its way to me. This applies to straightforward analyses as well as reverse analyses. When, e.g., stock analyst Steno says that "everyone expects a decline in H1 2023" and that he therefore does not, so I think both that he may be right and he may be wrong, but I weigh both reactions equally. When I hear US investor Druckenmiller say that his models point to a potentially very severe recession in late 2023, not likely later than that, I think mostly that it will probably actually be that way; and not at all that a recession occurs long before or after or not at all. Whether I react neutrally, with opposition or with agreement is influenced by my own current attitude, my own non-contrary analysis, as well as how good and long the track record, e.g., Steno and Druckenmiller have.

When I am currently thinking about the inflation dynamics in the coming year and the market's expectations and reactions to it, my conclusion is not fixed on a particular outcome but rather that "it will go in waves, that both the inflation measurements themselves and the reactions to them will fluctuate greatly". I think something similar about the price of oil and fossil gas, but mainly I think there that, despite an approaching recession, we are short of oil after many years of underinvestment. The world uses more fossil fuels every year and must continue to do so in order to expand renewable and sustainable energy sources such as solar, wind, hydro and nuclear power. That speaks for new record prices for oil sooner or later. It will be sooner if China kicks off in earnest, sooner if a recession becomes mild or avoidable, sooner if central banks tighten less (which interest rate markets are clearly signaling they expect), but later if we experience a severe economic slowdown. However, it doesn't matter much if record prices for oil take a while, because today's prices are already good enough to justify the stock prices of oil companies such as ConocoPhillips.

Perhaps some contrarians can also appreciate the irony that the more the world focuses on the expansion of solar parks, the more oil is used to dig up minerals and to build the parks, while investing even less in new oil fields. This means that it is then oil and oil companies that must be bought. Another slightly funny opposite-inspired approach is that the oil shortage can turn out to be so great that there will be such a price-driving bidding war for the oil that is available that it is precisely the higher oil price that causes higher costs and lower profit growth in other sectors. Such a development would accelerate the ongoing rotation from expensive "nice to have" growth companies to cheap "need to have" oil and mineral companies. There is plenty of room left in the market weights for such a move.

As for an economic slowdown and what it means for the companies' profits, I find it hard to see anything other than that the profit forecasts will be forced to be lowered sharply. It is due, among other things, to on higher input prices, rising wages, higher interest costs both internally in the companies and with their customers, as well as lower consumption space among end customers after lower real wages and rampant interest and energy costs, as well as reduced optimism and willingness to consume. Yes, a recession is coming and I think it will take hold before the Fed changes policy. It would quite frankly mean that the world is slowing down after a long period of overheating. It would just as straightforwardly mean that profit margins are coming down towards their historical average. It would, with the same clear logic, lead to both lower profits and lower multiples, i.e., much lower share prices for the average company.

So that would mean that the analysis becomes as simple as the same thing that happened in the recessions of 2002 and 2008 also happens in 2023: the economy slows down, profit forecasts fall, stock markets fall, investors rotate to companies with better cash flow multiples, and overall the stock market may even finally end up close to its historical average level, which in several cases is 25-50% lower than today (December 27, 2022). No, I'm apparently not a big fan of reverse analyses, but want to make my analyses simple and clear: If a company is still more expensive than about ten times earnings based on robust forecasts a few years into the future, then it's nothing for me, what "all" others than think. Today it leads me away from most of the stock market and towards sectors such as oil, mining and European banks. But certain specialist companies such as Meta, Spotify, Kindred and Elekta also get a place. They've gotten massively cheaper in the last year, so cheap that it doesn't matter to me anymore that they're in the wrong sectors. I think all of them may be the subject of bids after all the strong relative price movements in the past year, which I wrote a little about in the last column.

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