Examining the Consensus

 |  Includes: DIA, QQQ, SPY
by: Sean Hannon

Tuesday March 9 marked the one-year anniversary of the current stock market rally. During a 12-day span in 2009, the Dow Jones Industrial Average (Dow) lost over 1,000 points and closed at a bottom of 6,547. Since then, we have witnessed a relentless rally that has carried the Dow 61% higher in one year.

Looking back, everyone will describe how the market was oversold and the bottom in prices was predictable. However, when prices were cascading toward that low no such consensus existed. At the time, job losses were running in excess of 700,000 per month, threats loomed that our entire financial system was on the verge of being nationalized, and the economy looked to be entering the second coming of the Great Depression. With the backdrop so bleak, the consensus view called for the stock market destruction to continue.

In this case, the consensus was dead wrong and offers an example of the shortcomings of blindly following the consensus. Investing with the crowd can offer some benefits, but it also has drawbacks. Doing what everyone else is can offer you comfort, but groupthink tends to thwart creativity and crush independence, leading to few original ideas. Since original ideas are the framework of successful investments, following the crowd limits the likelihood of outperforming.

Recognizing the limits of following the herd, I often look at the broad consensus view and derive a series of alternatives. While these alternatives may not occur, examining them allows us to fully scope the landscape so unseen events do not derail our investment plans.

While no list can cover every consensus view, the main ones I see are as follows:

  1. Market Direction - With the broad market having started the year strongly, run into a soft patch, and then rebounded, most expect it to change little for the remainder of 2010. As stocks are now fairly valued, I agree with this view. However, we should never confuse a year-end estimate with daily volatility. Stocks could see a strong rally followed by weakness that leaves prices flat, but to those of us who invest every day, such a gripping move would feel extreme. Instead, I expect prices to move sharply. With recent strength, the technical patterns of the market are bullish and prices will rally over the coming weeks. However, each move higher stretches valuation and lends itself to a correction. We may be facing an environment where bulls, bears, and the crowd calling for a flat year all have their day in the sun.
  2. Geopolitical Risk Overblown - Many have their eyes on sovereign risk as European countries face default and China's economy approaches bubble status. At the same time, the consensus has dismissed these threats and believes everything will be fine. A contrarian view would expect these risks to multiply. Seldom does only one domino fall. Three years ago everyone felt subprime mortgage risk was contained until it ignited a firestorm. Small events have the tendency to morph into something bigger and we need to see if this is one of those times.
  3. The Economy Is Fine - I have been extremely vocal about my view that the economy is struggling. As the markets rushed higher following February's employment report, everyone seems to ignore that jobs were lost. Econometric models may gleam a bottom, but until sustained growth in employment occurs this will be a statistical recovery as those in the real world continue suffering.

As we survey the investment landscape, a sense of the consensus and possible exceptions keeps us focused. Markets will always evolve in unpredictable manners and those with a broad perspective are best suited to adapt to the unknown.