Contra bets in bad times

For risk takers, realty and capital goods may be good punt

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An axiom contrarians cite is that the market gets bullish when everybody is bearish in attitude, and vice versa. The logic behind this apparent paradox is simple. If demand exceeds supply, prices rise. And, prices drop when supply exceeds demand. When everyone is bearish, there is no supply of shares because everyone has sold. Conversely, when everyone is bullish, there is no demand because everyone has finished buying.

There is, of course, difficulty in diagnosing when “everyone” is either bullish or bearish. Money and stock holdings aren't evenly distributed across participants. A couple of large players can move supply or demand against the consensus opinion. A contrarian has to put greater weight on the opinions of large players and this is difficult to model.

We may have seen an example of the contrarian axiom in operation on a large scale through most of 2012. In January 2012, everyone, everywhere, was bearish about global economic prospects. Europe was in trouble and it looked as though it would get worse. The US was moving at a low growth rate. China had also seen its rate of growth falling. Indeed, things did get worse in fundamental terms. Spain and Italy went into crisis. Turmoil continued in the West Asia, with an escalating civil war in Syria and threats of military action by Israel against Iran. Growth rates in the US and China haven't picked up yet.

But the stock markets soared even though economic conditions remained troubled. Was this because the major players had already sold off whatever they wanted to, thus restricting supply of stocks? When the European Central Bank started its bailouts, some of the excess liquidity created demand as it was pumped into global equity markets.

On a much smaller scale, we might see this sort of contrarian rally across beaten-down cyclical sectors in India over the next six months.

Capital Goods and realty, for example, have both been troubled areas for a while. Profits are down across these two sectors. They were among the most hard-hit by the recessive conditions, high interest rates and escalating raw material costs. Both realty sector and the capital goods sector indices are down by around one per cent year-on-year.

Nobody is particularly bullish about the short-term prospects of either sector. Lack of investment by companies hurts the capital goods segment in terms of sales growth. At the same time, high interest rates and long credit cycles have pushed up their interest costs.

The real estate sector has also suffered from lack of demand, along with the occasional scandal that has hit perception. Again, demand is being hit by high interest rates and there's an element of desperation to all the developer ad-spam. The industry is seriously cash-strapped as well.

But the selling pressure in both sectors may have eased precisely because all these things are known and everybody has been bearish for a long time. That could put a floor on stock prices and a general improvement in sentiment may be creating the pre-conditions for a rally. Fundamental conditions will improve for capital goods once interest rates drop and the investment cycle picks up. Ditto for real estate.

Investments into depressed cyclical sectors are always a high-risk proposition. Acting upon the contrarian logic in general is also high-risk. There may be a considerable downside. Share prices can halve or drop by two-thirds in highly cyclical stocks. The potential rewards need to be commensurately high. Based on historical performance, this is not a problem. Once a bull market is firmly established, share prices in the realty and capital goods sectors can multiply several times. If you've got an appetite for risk, these sectors may be worth the punt for you.