Generally contrarians do well at turning points in the macro economy. That is, buying losers or selling winners from some past period. The contrarian approach did well when the internet bubble burst, the bear market ended in 2003, and the bear market ended in 2009. All other times it is better to follow momentum in stocks. As the economy grows stocks will perform better. We will not discuss the reason for turning points but the relevant take-away is that contrarian strategies have to be focused on a change in the status quo.
So what does it mean to be a contrarian in 2010? The financial sector did well and stocks in general did well. Should you avoid banks and equities in general? That would assume that growth prospects for the US economy are actually going to be lower than the most recent numbers. In the face of strong government stimulus, it is not clear that being a contrarian is a sure bet.
One reason for being a contrarian is based on the relationship between operating leverage, the business cycle and profits which are all closely tied. When the economy turns down and there is a fall in top line growth, there will be a squeeze in profit margins. This is especially true if there is a shock to top line revenues such as a the create crisis. Sales will fall faster than expected and there will be inventory build. Margins fall because the operating leverage does not change with decline in sales.
So what does it mean to be a contrarian in 2010? The financial sector did well and stocks in general did well. Should you avoid banks and equities in general? That would assume that growth prospects for the US economy are actually going to be lower than the most recent numbers. In the face of strong government stimulus, it is not clear that being a contrarian is a sure bet.
One reason for being a contrarian is based on the relationship between operating leverage, the business cycle and profits which are all closely tied. When the economy turns down and there is a fall in top line growth, there will be a squeeze in profit margins. This is especially true if there is a shock to top line revenues such as a the create crisis. Sales will fall faster than expected and there will be inventory build. Margins fall because the operating leverage does not change with decline in sales.
Now in this case many companies reacted quickly to the decline in sales with lay-offs. The objective was to cut operating expenses as quickly as possible given the size of sales decline. the expected severity of the recession caused a quick reaction. The cost structure was able to adjust quickly in 2009 which lead to better than expected profits. Analysts did not expect that companies would be able to control costs as quickly as they did. Now the question is whether companies will be able to maintain margins if there is a turn up in the business cycle. If there is a strong recovery, margins will increase quickly.
The success for 2010 in equities may have more to do with how companies control operating margins as opposed to overall sales growth. The contrarian story may be based on the company cost control and not sales growth estimates.
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