Contrarian investors know that following the consensus is a sure way to lose money in the markets, says Niels C. Jensen at Absolute Return Partners. Most 'truly great fortunes' are made by going against the crowd. Here are six themes he believes investors should consider betting against this year...
When embarking on a new investment, it is always advisable to take the temperature on the market, also called the consensus view. Most of us probably recognise the comfort it gives us when our friends and colleagues confirm our views. Few people can honestly say that they are
immune to this.
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However, this is not the reason the consensus view is important. Quite frankly, it is important to know the consensus view, because it is more often wrong than right. Why is that? Are we suggesting that the majority of investors are stupid? Not at all. It would not only be arrogant to suggest that but also factually incorrect.
In order to understand why the consensus view is often (but not always) wrong, it is important to understand how it is formed. It shouldn't
surprise you that the best investments are usually those that not everyone has discovered. When a new investment trend is borne, it usually begins with some really smart investor sticking his neck out long before the rest of us can see the light.
Once he has established his position, he starts using the oldest trick in the book. We call it Get Long and Get Loud. He will be the person at the dinner party whispering in your ear that you should buy shares in this oil company in the Falklands Islands that nobody has ever heard of. The problem is, at this stage, your reaction is likely to be indifferent at best, because it is not yet a widely held view.
Now imagine what happens next. A few people, who know the track record of the person in question, actually buy into his recommendation. Slowly but surely, the idea spreads. Two years later, the worst kept secret in the world is that you should fill up your portfolio with small oil exploration companies in far fetched corners of the world. At this point the really smart guy sells his shares.
No prize for guessing who makes the most money. And the poor soul who bought it last is likely to lose his shirt. Along the way the theme became the consensus view. And, precisely at that time, it went from being a money-making to a loss-making proposition.
Therefore, more often than not, it is not commendable to follow the consensus view. The odds are stacked against you. Instead, you want to invest in themes which are not yet consensus views. That is how the truly great fortunes have always been made. Unfortunately, it is also the more difficult thing to pull off.
We shall now look at what we believe are some of the biggest consensus trades for 2006. The bad news is, if you recognise every theme as
being in tune with your current portfolio, you may be in for a rough time in 2006.
Just one final health warning before we go through the list. The consensus views expressed below represent our views and our views only. Please forgive us if we missed one or two important ones. And now to the list:
# 6: The Euroland economy to recover
You may ask, what economic revival? Fair question. The signs of revival are not yet very robust, but the strong surge in European share prices last year is testament to the fact that many investors expect better times ahead for the lethargic nucleus of Euroland, France, Italy and Germany (the FIG countries).
As a result of stronger growth expectations, the market also expects European interest rates to rise modestly. The overnight rate appears to be heading towards 2.75%, and the 10-year bond is heading towards 4% from 3.48% currently. That is if you believe the consensus view.
The risks to this view are many. We will highlight just one. If the governments of the FIG countries continue their current line of economic policies, we will bet a great deal that economic growth will disappoint yet again, not only in 2006 but also in 2007. Therefore we think the risk to long bonds in Euroland is on the downside as far as yields are concerned.
# 5: Commodity prices to carry on rising
This view is largely attached to the general belief that strong economic growth in Asia, and particularly in China and India, will cause commodity prices to rise for years to come. One interesting aspect about commodity prices is that, although many are bullish, not so many have in fact positioned themselves accordingly.
Take the pension fund industry. It is our understanding that many pension funds are still struggling to come to terms with this asset class. How do they get their exposure? etc. etc. Partly for this reason, the odds may be tilted in favour of the consensus view in this instance.
However, the consensus conveniently ignores the fact that commodity prices are extremely sensitive to economic up- and downturns, so although the underlying trend may be up, investors could very well be in for a rough ride, if the global economy softens later this year.
# 4: Gold prices heading higher
Gold usually does well when inflation expectations are on the rise. Likewise, a weak U.S. dollar is often linked with a rise in the precious metal. The recent run in gold prices should therefore tell us something about inflation expectations and the consensus view on the dollar (which we will get to in a second or two).
A fact often ignored by the gold bulls is that demand for gold is very seasonal, and we happen to be at the tail end of the peak season. For us, the jury is still out. We will be a lot more impressed if gold can sustain its rally into the spring and summer.
# 3: The Fed has almost done the job
It is now widely accepted that the Fed is almost done with its series of rate hikes. We have one, maybe two, hikes to go, taking the Fed Funds rate to 4.75% at worst. The very weak GDP report released last Friday only reinforced this view.
The equity bulls use this argument to build a case for buying U.S. equities. For the first time in years we have actually seen prominent European fund managers advocating an overweight in U.S. equities relative to European equities.
The main risk to the view on Fed policy is inflation. The impact from higher oil prices has been subdued so far, but do not ignore the fact
that last Friday's GDP report also included not so good news on consumer inflation in the U.S.
We know that the Fed governors are concerned about the inflation outlook. We saw in last week's report that this concern may be justified. The risk to the market is obvious. The Fed may not be as close to the end of this cycle as many expect. If the Fed Funds rate has to go 5.50% or perhaps even 6%, in order to take the air out of the looming inflation bubble, things could get pretty ugly.
# 2: U.S. imbalances are unsustainable
This is a big one. It is an opinion held almost universally, and we cannot do the subject any justice in a paragraph or two. The view itself is straight forward. A large (and growing) trade deficit combined with a spiralling budget deficit is a disaster waiting to strike. Sooner or later, the view goes, interest rates will have to go up, and the U.S. dollar will have to fall, in order to address those imbalances.
Well, in our opinion, things are not that simple. Historically, imbalances have been adjusted through exchange rates rather than bond yields, so history suggests that we should worry more about the dollar than the 10-year treasury yield.
The dollar, however, is not just a function of trade patterns. Other capital movements are important to the value of the dollar. Which currencies do the central banks hold much of their reserves in? Where do the Indians and Chinese invest their savings? The outlook for the dollar is, in our opinion, not as one-sided as many people seem to think.
# 1: Japanese share prices to go up and up
This is probably the biggest consensus trade of them all. We have been struggling to find anyone not bullish on Japanese equities. Is it because we don't speak to domestic Japanese investors?
Apparently, they are not (yet) very bullish. Or that is at least what the bulls are telling us. We have to make a confession here. We like
Japanese equities too. Partly because we believe the Yen is undervalued. By buying Japanese shares and not hedging your currency risk, you have an interesting two-way bet, although we cringe when using the word bet in the same sentence as discussing investments.
What could go wrong? In our opinion, there are two big risks to this consensus view. The war against deflation may in fact not be over yet and, secondly, Japan's economic wellbeing is frightfully dependent on growth elsewhere, as much of the revival has been export driven. The U.S. economy hit a brick wall in the fourth quarter of last year as reported last Friday.
Japan is dependent on the U.S. economy both directly and indirectly. Indirectly, because China is now Japan's largest export market, and China's biggest export market is the United States.
Other Consensus Themes
The list above is by no means complete without a brief mention of some of the other important investment themes that seem to dominate the
world.
House prices have proven such a powerful fuel for the spending spree that consumers in the Anglo-Saxon world, Spain, Scandinavia, etc. have enjoyed in the last few years. Most people seem to believe that a soft landing for house prices is the most likely outcome. One wonders what would happen if the outcome is not so benign.
The inverted U.K. yield curve suggests a high probability of a recession looming in the UK, but the consensus view appears to be that the UK economy is heading for a more modest slowdown. Has the yield curve lost its predictive powers or is the market ignoring the obvious?
The small adjustment last summer of the renminbi was, in the opinion of a large majority of the market, hopelessly inadequate, and the consensus view seems to be that there is only one way to go for the Chinese currency further appreciation. This view completely ignores the fact that the value of the Chinese currency is dictated by the policies set by the Chinese leadership. Do not be surprised if the change in value of the renminbi over the next few years proves to be very minor indeed.
Conclusion
Obviously, some of the consensus themes above will turn out to be spot on. Others will perhaps be proven correct eventually, but the timing was off. And some will turn out to be embarrassingly inaccurate.
If history repeats itself - and it often does when it comes to market psychology - more than 50% of the consensus views discussed above will prove to be money-losing propositions in your portfolio in 2006.
It would therefore be an interesting exercise to create a portfolio consisting of ideas which go against all the big consensus themes. You would be far more likely to make a good return on that portfolio than if you were just to follow the herd. It requires courage, perhaps even a regular dose of Imodium, to do so. But the odds will now be in your favour.
By Niels C. Jensen, chief executive partner at Absolute Return Partners LLP. To contact Niels, email: njensen@arpllp.com
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