Serious Money: Conventional wisdom is one of those overused phrases that can mean different things to different people, but is often of critical importance when assessing where markets are likely to go next, writes Chris Johns.
Indeed, trying to guess what the market believes is central to the type of investor that believes in taking the opposite stance to the one adopted by most market participants. Investors who adopt a contrarian stance believe that conventional wisdom is often wrong or, when it is right, asset prices still get overcooked in one direction or another.
In terms of individual stocks, this can mean that where it was once right to buy shares because of intrinsic cheapness and/or better growth prospects, for example, markets being what they are often take such views to extremes. In such circumstances, stock valuations can reach levels that are way beyond those suggested by the original analysis. What was not in the price now becomes over-discounted: stocks rarely move to fair value and sit there, they tend to overshoot.
In terms of broad asset classes, contrarians look for extremes in market opinion that they can bet against. The dollar earlier this year is a classic example.
Virtually every single currency forecaster in the world thought that the dollar/euro exchange rate would push on to €1.40 and beyond once the €1.30 level had been broken. In terms of hard data - as opposed to mere opinions - we could see via numbers supplied by various futures exchanges that traders had committed unprecedented levels of capital to a bet that the dollar's fall would continue.
What happened next was, of course, a big reversal in the dollar's fortunes and a quick move back to €1.20 ensued. Contrary currency speculators could have made a fortune.
Conventional wisdom is still firmly in the dollar bearish camp. There is no analysis of the macro problems facing the US and world economies - unprecedented large and growing balance of payments deficits - that suggests the dollar can strengthen from here. Prominent investors like Warren Buffet have placed large public bets that the US currency will resume its decline and could fall a long way. Speculators seem to be more circumspect than they were, probably because of the extent to which they were burnt earlier in the year.
That consensus view about the dollar also has echoes in the conventional wisdom surrounding US equities. That analysis of US fiscal and trade imbalances also says that any move back towards a more sustainable situation must involve lower US growth, perhaps even a recession, higher interest rates and bond yields and, therefore, lower equity prices. Merrill Lynch's monthly survey of investor sentiment recently revealed that global money managers are more negative about the US stock market that they have been for some time.
Sentiment is often driven as much by what has happened as what is likely to occur. It is no coincidence that negative attitudes towards US stocks comes after a period when the Dow Jones and S&P 500 indices have traded sideways all year. It was right to have been relatively cautious about US stocks. Having a view that has been right is a comfort zone for too many backward-looking investors.
Commentators are now falling over themselves to warn us about an impending slowdown in the US. Those higher petrol prices are going to take a huge bite out of disposable incomes and the American consumer has no safety cushion by way of savings. Either he is going to have to borrow even more or cut back on other expenditures. Lower growth equals a significant risk to the stock market in the consensus view.
Contrarians might want to examine this a bit more closely. The bearish view makes the simple point that the US stock market has stood up well in the face of a stream of bad news. There must, according to this analysis, come a tipping point. The economic newsflow is bound to deteriorate further and that will hit the stock market. Equities cannot continue to take it on the chin.
The weakness of this line of reasoning is that the stock market has, in fact been quite weak, possibly starting to price in exactly the kind of band news that the bears suggest is being ignored. How can a market that is virtually unchanged in the year to date be described as weak?
The answer lies with a little digging into movements in US share prices at the sector level. To the end of last month, every major sector of the US stock market bar energy, utilities and healthcare is down for the year.
Consumer stocks exposed to discretionary expenditures have been the hardest hit, showing an average fall of 9.5 per cent. Telecommunication stocks are down 8.5 per cent, financials down 4.8 per cent and even consumer staples are slightly down. The reason why the overall market has held up has a lot to do with a 31 per cent rise in energy stocks, a direct consequence of higher oil prices (which, indirectly, also help the profitability of utilities). The 3.4 per cent rise in healthcare stocks is exactly what you would expect in a bear market - the fact that conditions have amounted to a stealth bear market seems to have been missed by some analysts. High oil and commodity prices have led to a boom in the relevant stocks, which has concealed quite dramatic moves in other sectors.
The contrarian would begin to suspect that all the doom and gloom about the US outlook is now some way to being in the price. In which case, it could be tempting to argue that conventional wisdom about the US is dead wrong and that American equities might turn out to be better performers than most people seem to expect.
Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.
