If you go around and ask people what their current take is on the markets and the economy, most will say that a recession is coming. A lot of data supports that notion — the inverted Treasury yield curve, housing starts, the slowdown in manufacturing. A recession may ultimately end up happening before all is said and done, but I’m concerned about the number of people saying it will.
Successful investing is all about probabilities, but it’s also about relative value. Something may have a high likelihood of occurring, but if there’s little reward for being right about the outcome, an investment may not make sense. In some cases, betting on a low-probability event can make more sense. There may not be much of a chance that you’ll be right, but if you are, the payoff can be huge! These are the kinds of risk/reward trade-off decisions that investors constantly need to make.
I see one such opportunity right now in betting on a recession. If everyone is so certain that this will happen, taking the contrarian position — that a recession won’t happen – may provide investors the better value.
Let’s look at a simple example. Let’s say there are 10 envelopes on a table and one of them has a $20 bill in it. For the cost of $1, you can choose and keep the envelope you believe has the money in it. Should you take the bet?
Statistically speaking, the answer is yes, even though there’s a 90% chance you’ll choose the wrong envelope. Why? The payoff in being right that one time out of 10 more than makes up for the times you’d be wrong. If it costs you $10 to make 10 attempts at finding the envelope and you hit it that one time, you get the $20 bill and end up a net $10 ahead (yes, there’s a chance the person may guess incorrectly 10 times, but you get the idea). The probability of winning on any single guess is low, but the overall value is much higher.
If we look at a simple chart of the S&P 500 over the past 30 years, we get two clear examples of how taking the contrarian side would have paid off big time.
Contrarian Investing: Lessons Learned
During the tech bubble, everybody believed that the internet was going to be revolutionary and tech stocks would only keep going up. The tech wreck ended up slicing more than 80% off the value of the Nasdaq 100. During the financial crisis, homeowners thought that property values would only keep going up. The housing market and the U.S. economy nearly collapsed when consumers and banks got completely overleveraged.
Which brings us to the present time. If everybody truly believes that a recession is imminent, does it make sense to consider taking the contrarian point of view because the potential value is higher? It’s impossible to know which path will be the correct one, but it’s worth emphasizing how important it is to consider all possible outcomes and not just follow the crowd.
A big part of my research is all about trying to identify trends and conditions before the market does. That often involves taking positions opposite of what the market believes will happen. It often feels uncomfortable, but the potential gains that could come as a result of swimming against the stream may be significant.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
