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Contrarian Thinking

Niall Ferguson’s paper caught my attention. He investigates how investors mispriced bond market risk in the years leading up to World War One- bond market yields fell and risk premiums shrunk right up to one week prior to the start of hostilities.

The main question addressed is why political events appeared to affect the world’s biggest financial market, the London bond market, much less between 1881 and 1914 than they had between 1843 and 1880. In particular, I ask why the outbreak of the First World War, an event traditionally seen as having been heralded by a series of international crises, was not apparently anticipated by investors. The article considers how far the declining sensitivity of the bond market to political events was a result of the spread of the gold standard, increased international financial integration, or changes in the fiscal policies of the great powers. I suggest that the increasing national separation of bond markets offers a better explanation. However, even this structural change cannot explain why the London market was so slow to appreciate the risk of war in 1914. To investors, the First World War truly came as a bolt from the blue.

The paper explores this question from both a quantitative and qualitative perspective. The bottom line is everyone knew that a major European War would be economically damaging (I would argue WWI cemented the decline of British power), that risk premiums were at historic lows, and that destabilizing events continued to unfold in the years leading up to 1914.

Given the momentous financial consequences that a major war was expected to have, any event that made such a war seem more likely, even if only momentarily, ought to have had a detectable effect on the bond market. In other words, if the Moroccan, Balkan, and other crises truly were harbingers of a war between the great powers, investors should have reacted to them by marking down the prices of the bonds issued by the expected combatants.

But they didn’t. I’m sure most of the contrarians who were shorting the bond market while war approached got cleaned out long before their viewpoints were vindicated.

Investors become too comfortable during periods of low risk, and are caught off guard when Political, Military, or Economic risks are ultimately realized. Many events exhibit this effect. The Nifty Fifty. The Four Horsemen. The Dot.Com Bubble. In hindsight, the mispricings appear obvious, but the herd mentality dominates in the short term.

I would venture that people who recently had flat tires are more prone to checking the condition of their new replacements. This is the essence of being a contrarian. The guy who checks the air pressure in his tires even when he has never had a flat, even when his friends and family taunt him.

Bastiat captured this philosophy perfectly.

In the department of economy, an act, a habit, an institution, a law, gives birth not only to an effect, but to a series of effects. Of these effects, the first only is immediate; it manifests itself simultaneously with its cause – it is seen. The others unfold in succession – they are not seen: it is well for us, if they are foreseen. Between a good and a bad economist this constitutes the whole difference – the one takes account of the visible effect; the other takes account both of the effects which are seen, and also of those which it is necessary to foresee. Now this difference is enormous, for it almost always happens that when the immediate consequence is favourable, the ultimate consequences are fatal, and the converse. Hence it follows that the bad economist pursues a small present good, which will be followed by a great evil to come, while the true economist pursues a great good to come, – at the risk of a small present evil.

- Frederic Bastiat, “That Which is Seen, and That Which is Not Seen“, 1850

With sufficient capitalization, Bastiat would have been the ultimate short-seller.

What is unseen today? What is the market missing? This is what drives us…

Hat tip to Paul Kedrosky for the great paper


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