Contrarians know well that commonly-held misconceptions can be the source of investment profits. Simply catch an overwhelming majority of investors leaning too far in one direction — and pinpoint the overlooked folly in their rationale — and you have the makings of a trend reversal that can pay you handsomely.
Of course, taking a contrarian trade can feel like entering Fenway Park at the conclusion of a World Series game. It’s difficult and most people will think you’re lost, crazy or drunk.
Similarly, betting against Germany — the euro zone’s undeniable stalwart — is no easy feat. Yet, a bit of technical analysis shows that shares of German stocks may be overextended, while Spain’s stocks are undervalued.
For orientation, the declining trend from 1995 through 2003 indicates Spain’s outperformance of Germany. Then, following the global financial crisis of 2008, Germany overtook Spain as the best European market to buy.
But recently, this ratio has shown signs of weakness (right red line) precisely in the range where traders commonly look for trend reversals to occur (blue lines). That means it’s highly probable that Spain’s shares will outperform Germany’s over the next several months.
German stocks have been bid up to expensive levels thanks to a herd-like mentality that’s read: “If we’re gonna buy Europe, we’d better buy Germany.” Years of this has pushed the price of many German stocks into overbought territory.
Look at this next chart and you’ll see shares of Germany’s prized exporter, Siemens (NYSE: SI), are up 175% since March 2009.
Meanwhile, shares of Spanish companies, like the $75 billion telecom giant Telefonica, S.A. (NYSE: TEF), have been beaten down by that same herd-like mentality to avoid anything Spanish. Shares of Telefonica are down 8% since March 2009.
To take advantage of the trend reversal that Spain will become the favored market in the next couple of months (as my technical analysis shows me is in the cards), contrarian investors could make one of the following pairs trades:
- Buy Spain (NYSE: EWP); sell Short Germany (NYSE: EWG), or
- Buy Telefonica (NYSE: TEF); sell Short Siemens (NYSE: SI).
What’s more, option B gives you an annual net yield of nearly 3.5% since owning Telefonica could pay you 5.64% a year in dividend payments, while you’ll owe 2.2% a year to sell short Siemens’ stock.