“You make real good money by finding a commonly held perception that’s wrong and betting against it.”
George Soros
My wife Anne and I went to see the movie World War Z last weekend. While it was entertaining, there was a moment in the movie that resonated with me and reminded me of the above George Soros quote. The movie is about a Zombie plague that spreads rapidly around the world. Different countries react differently but Israel actually had the foresight to build a wall just weeks before the outbreak. When asked how they were so smart, the character explained a philosophy that the country developed called “The 10th Man” rule. It was designed to recognize the dangers in a consensus view of the world. Basically, a committee of 10 people is maintained and if 9 people agree without question about the probability of an inherently unknowable future event, it is the job of the 10th person to veto the consensus and direct the committee to plan for the opposite outcome.
I have learned many times that joining the consensus is dangerous when it comes to investing. And just when the consensus is practically at 100%, the opposite starts to occur as there is nobody left to join the party. Following the herd might seem safe but it is easy to get trampled if you get distracted.
Contrarian investors find themselves uncomfortable in crowds. They often take the other side of the consensus view and become famous if proven correct. There were books written about a few very insightful investors who made fortunes betting against the consensus leading up into the 2008 financial crisis. George Soros made billions betting against the consensus around the British Pound years ago and is still living off of that one call.
The problem with this type of investing is that it is hard to go against the consensus. Few can stay “wrong” long enough and that is what makes the approach so hard to implement. Value investing is a type of contrarian investing because value investors see value where the market doesn’t. The market can take a very long time to realize that value and the value investor needs patience and fortitude to appear wrong until they are rewarded.
Warren Buffett is the celebrity value investor of our times. But even he has had very long and persistent losing streaks by going against the consensus. During the technology bubble at the turn of the century, Warren looked foolish for several years as the markets kept hitting new highs and all the while he lagged because he would not join the consensus. He was even on the cover of Fortune, portrayed as not getting the “new economy”. He looked at fundamentals and was convinced that valuations were unsustainably high and a reversion to those fundamentals would happen sooner or later which of course they did in spectacular fashion.
While everyone wants to invest like Warren, few have the fortitude to really do so. During the darkest days of the financial crisis, he was very vocal about investing new capital when many were selling into the panic. He knew he could not call a bottom (and in fact was months too early as it turned out) but he saw value and his reputation has grown. During these 2 market extremes, he recognized an overwhelming consensus and did the exact opposite. That is what makes Warren the greatest investor of our times. He has learned over a lifetime to control the basic investing emotions of Fear and Greed.
In my market letters over the last couple of years, I have discussed the bond market and referenced the prevailing 10 year US Treasury yields. The bond market is many times larger than the stock market and is widely regarded as the “smarter money” so bond yields are closely watched. Many times I have asked rhetorically who was “investing” in these incredibly expensive “safe” investments and I suggested that many participants were “renting” the positions with no intention of holding the bonds until maturity. I suggested there was a “bigger fool theory” at work as in, somebody else will get stuck when the music stops. Well at the beginning of May, the 10 Year US Treasury yield was priced to return about 1.60% per year to maturity. That means, if you invested on May 2nd with the intention of holding the bond for the 10 years to maturity, your return would be 1.60% each year for the next 10 years. This return is of course before taxes and inflation. Just 2 months later, those who made that “safe” investment have lost about 10% of their capital as the bonds have depreciated that much, adjusting to the prevailing 2.70% yield.
The biggest, smartest market in the world built an overwhelming consensus that is looking completely wrong just 2 months later. And as the markets adjust their thinking on interest rates, many dividend yielding stocks that were beloved just a month ago have been thrown out with the bath water. Some are down over 20% from their recent highs.
The majority view is not always right and very often, the bigger the consensus, the greater the risk. So I want to point out a couple of other consensus views that are driving markets at the moment. First of all, the markets have decided that there is no inflation on the horizon. The price of gold has collapsed since early April and actually recorded its worst percentage drop on record last quarter. The overwhelming consensus is that gold is practically radioactive. Many gold stocks are trading at lower levels than in 2008 even though gold is still some $500 higher since those days.
Another consensus that has emerged is that the American economy is in the best shape of anywhere in the world (or said another way, “best house in a bad neighborhood”). US stock indices have enjoyed one of their longest winning streaks on record until experiencing a 7% correction recently. The only other market that has had strong performance this year has been Japan’s stock market. Coincidentally, these are the 2 countries that have engaged in massive Quantitative Easing (QE) programs with one of the primary stated objectives of QE being to create inflation. Japan is printing 3 times more currency relative to their economy than the USA has been printing. Yet there are absolutely no inflation worries?
The TSE is negative YTD as commodity stocks have been shunned in favor of the better performing US and Japanese stocks. This may remain the case until markets begin to at least contemplate inflation risks. While hard to do, I am trying to play defense and offense at the same time, and watching out for consensus thinking and the dangers it represents in this uncharted territory.