I wasn't always a momentum investor.
Like many of you, I began my career as a contrarian investor. After all, some of history's most successful investors have been contrarians. Baron Rothschild, Warren Buffett, George Soros -- all made their fortunes in part by betting against prevailing market opinion.
Baron Rothschild, often considered to be the father of contrarian investing, was a London-based financier in the 18th century. You probably know him from his most famous piece of investing advice: "Buy when there's blood in the streets."
Rothschild invested in beaten-down British bonds while Britain, and most of Europe, were at war with the French. It was risky. If the British had been defeated, which was a real possibility, the bonds would have been worthless. But Rothschild ended up making a small fortune once the British defeated Napoleon's army in the Battle of Waterloo.
Centuries later, contrarian investors are still finding success.
George Soros is best-known for making one of the boldest trades in history, contrarian or otherwise. He infamously sold short about $10 billion in British pounds in 1992, betting that the value of the currency would fall relative to the German Deutsch Mark.
It was the ultimate contrarian play, since the British government's "full faith and credit" had vowed to maintain a fixed exchange rate between the two currencies, and it paid off. Soros netted a $1 billion profit when the U.K. devalued its currency.
Warren Buffett, in the midst of the financial crisis in 2008, famously said, "A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful." There was plenty to be fearful of at the time. The S&P 500 had fallen 35% in a year, and many believed the entire financial system would collapse.
Despite that, Buffett invested $5 billion in Goldman Sachs (NYSE: GS). In return, he received $5 billion in preferred shares that paid a 10% dividend plus the right to purchase $5 billion shares at $115, even though they traded at $125 at the time. The savvy investment generated 64% returns for Buffett by April 2013.
Of course, none of these classic contrarian trades would have played out for regular investors.
Rothschild, for example, was so well connected that he knew the British had beaten back the French at Waterloo a full day before the government. Legend has it, he made over a million pounds with that bit of "insider" information.
As for Soros, he essentially made his bet pay off by engineering the downward move in the pound. He used billions of dollars and his influence to generate the immense selling pressure that caused the currency to collapse.
And Buffett used his wealth, political connections and near-mythical stature as a white knight investor to forge the Goldman deal. So while Buffett's investment generated 64%, you or I would have had to settle for 16% gains.
These examples are extreme, but the point is, the average investor doesn't have the capital, political connections or market clout to be a true, blood-in-the-streets contrarian.
You see, the problem with contrarian investing, which for most investors simply means buying beaten-down or cheap stocks, is that you can be "right" and not make money. An undervalued stock, for example, can stay cheap for years.
Stocks don't go up because they're beaten down; they go up because there's demand for those shares. So instead of purchasing underperforming stocks and trying to "catch a falling knife," the secret is to wait for demand to take root, indicated by a pick-up in relative strength.
You might not get in right at the bottom using this "contrarian momentum" strategy, but it will certainly help you avoid stocks that don't go anywhere, or worse, lose money. It's less risky and can still lead to significant gains.
Let me show you an example of what I mean with alternative energy stocks. The sector has been on fire for the past year, but that wasn't always the case.
No sector was more hated than alternative energy in the early part of the decade. As measured by the Market Vectors Global Alt Energy ETF (NYSE: GEX), the sector was down nearly 81% from 2010 to 2013. For comparison, the second worst performing sector, U.S. banks, was up 9.2% during that time. Meanwhile, the S&P 500 gained 52.3%.
This sector was the ultimate contrarian play, as you had to be a very big believer in a potential turnaround in order to start putting money to work in the space.
Interestingly, that's exactly what started happening in June 2012, when the sector essentially bottomed and began actually outperforming the S&P 500. This was followed by a strong six-month period of outstanding relative strength, and since then, GEX has really turned on the juice.
In the last six months of 2012, alternative energy outperformed the S&P 500, gaining 21.7% versus 15.9% for the index. If you had waited to purchase alternative energy stocks until they had strong relative strength, you'd be up 196%. The point is that you don't need to perfectly time a bottom to generate huge gains in "hated" sectors or stocks.
But alternative energy isn't the only sector showing strong momentum right now. Below are six other sectors that have recently started to show signs of a turnaround.
Aside from alternative energy, industrial metals and mining stands out. It has only returned 6.3% since September 2011, while the market is up nearly 95%. However, the sector now has strong momentum. It has outperformed the market by nearly double over the past six months.
This could be the start of the next big contrarian momentum move, similar to what we're seeing with alternative energy.