Beat the Crowd

1. Contrarianism: Think differently, not oppositely

To beat the crowd, you want to be on a perpetual hunt for Jack and Walter. Things everyone knows in the back of his or her mind but ignores.

True contrarianism involves thinking independently, not simply doing the opposite of the crowd. Most investors fall into two herds: the mainstream and the opposite-doers. Real contrarians analyze both herds' thinking, weigh all factors, and reach their own conclusions.

Contrarian thinking requires:

• Identifying widely-held beliefs and expectations
• Questioning assumptions and challenging conventional wisdom
• Seeking overlooked information and alternative perspectives
• Developing unique insights based on independent analysis

By thinking differently rather than oppositely, contrarians can spot opportunities others miss and avoid common pitfalls. This approach allows investors to be right more often than wrong, even if perfection is impossible.

2. The market's 30-month vision: Focus on the near future

If we knew for a fact, with perfect 20/20 vision, the world would end on December 31, 2020, stocks wouldn't start pricing it until about 2018 at the earliest.

Markets are forward-looking, but only to a point. They typically focus on the next 3 to 30 months, with the greatest emphasis on the 12 to 18-month range. This "market vision" has important implications for investors:

• Long-term forecasts and trends beyond 30 months are largely irrelevant for current stock prices
• Short-term noise and daily fluctuations are equally unimportant
• Investors should concentrate on factors likely to impact economies and businesses within this timeframe

To apply this concept:

• Ignore apocalyptic predictions and societal issues beyond the 30-month horizon
• Focus on near-term economic indicators, policy changes, and business trends
• Assess how current events and developments might play out over the next year or two

By aligning your analysis with the market's timeframe, you can better anticipate potential moves and avoid getting caught up in irrelevant long-term fears or short-term noise.

3. Identifying market elephants: Spot overlooked opportunities

The elephant in the room is jam-packed with surprise-power mojo. It's the big thing that has always been there, and everyone knows about, but they've forgotten.

Market elephants are significant factors or trends that are widely known but often overlooked or forgotten. These "elephants in the room" can provide powerful contrarian opportunities when rediscovered.

Characteristics of market elephants:

• Well-known information that has become too familiar to notice
• Historical patterns or truths that have faded from memory
• Fundamental principles temporarily obscured by market noise

Examples of market elephants:

• The power of compound interest in long-term investing
• The cyclical nature of sector performance and leadership
• The importance of the yield curve in predicting economic growth

To spot market elephants:

1. Study financial history and classic investment literature
2. Question commonly held beliefs and "common sense" wisdom
3. Look for disconnects between market behavior and fundamental principles
4. Pay attention to overlooked or underappreciated data points

By identifying and acting on these overlooked factors, contrarian investors can gain a significant edge over the crowd.

4. Political gridlock: A boon for markets

The more laws Congress passes, the higher the chance they could redraw property rights, rewrite regulation or redistribute wealth, resources and opportunity—all negative.

Gridlock is good for markets, contrary to popular belief. While voters and the media often bemoan political inaction, markets thrive on the stability and predictability that gridlock provides.

Reasons gridlock benefits markets:

• Reduced regulatory uncertainty
• Lower likelihood of disruptive policy changes
• Preservation of existing business and economic frameworks

Historical evidence supports this view:

• Years 3 and 4 of presidential terms often see higher returns due to reduced legislative activity
• Markets have performed well during periods of divided government

Investors should:

• Be wary of promises for sweeping economic changes
• Consider the likelihood of gridlock when assessing political risks
• Look beyond surface-level political drama to understand true market impacts

Remember that markets prefer the devil they know to the uncertainty of new policies, regardless of partisan leanings.

5. Behavioral finance: Master your emotions, not the market

Behavioral finance was never meant to be a marketing tool—again, it's a self-control tool.

Self-control is key in applying behavioral finance principles. While many modern approaches claim to exploit others' behavioral errors, true behavioral finance focuses on identifying and correcting your own cognitive biases.

Common behavioral pitfalls:

• Recency bias: Extrapolating recent trends indefinitely
• Confirmation bias: Seeking information that supports existing beliefs
• Loss aversion: Feeling losses more acutely than equivalent gains
• Herding: Following the crowd without independent analysis

To master your emotions:

1. Recognize your own biases and emotional triggers
2. Develop a systematic, rules-based approach to investing
3. Regularly review and challenge your assumptions
4. Seek diverse perspectives and contradictory evidence
5. Practice patience and discipline in the face of market volatility

By focusing on self-control rather than attempting to outsmart others, investors can make more rational decisions and avoid common behavioral traps that lead to poor performance.

6. The power of history: Learn from financial classics

Classics are classic for a reason!

Financial history repeats, making classic investment literature an invaluable resource for modern investors. These works provide timeless insights, historical context, and a foundation for critical thinking about markets.

Essential classic reads:

• "The Intelligent Investor" by Benjamin Graham
• "Reminiscences of a Stock Operator" by Edwin Lefèvre
• "Common Stocks and Uncommon Profits" by Philip Fisher
• "Where Are the Customers' Yachts?" by Fred Schwed

Benefits of studying classics:

• Gain perspective on market cycles and human behavior
• Understand the origins of modern investment theories
• Develop a contrarian mindset by challenging conventional wisdom
• Learn from the successes and failures of legendary investors

To maximize learning from classics:

1. Read with a critical eye, considering how principles apply to modern markets
2. Look for recurring themes and patterns across different eras
3. Compare historical events to current market conditions
4. Apply timeless wisdom while adapting to evolving market structures

By grounding your investment approach in historical knowledge, you can better navigate the complexities of today's markets.

7. Professional forecasts: A contrarian's crystal ball

Professional forecasts have a remarkable tendency to cluster.

Consensus forecasts provide valuable contrarian insights, not because they're accurate, but because they reveal what's already priced into the market. By understanding professional expectations, investors can identify potential surprises and opportunities.

How to use professional forecasts:

1. Collect a wide range of forecasts from various sources
2. Identify the consensus view or "cluster" of expectations
3. Consider what would happen if the consensus is wrong
4. Look for potential outcomes not widely anticipated

Key points to remember:

• The actual forecast numbers are less important than the general direction and magnitude
• Markets are more likely to do something different than what most professionals expect
• Outlier forecasts can provide valuable alternative scenarios to consider

By viewing professional forecasts as a tool for understanding market expectations rather than predicting outcomes, contrarians can gain a significant edge in positioning their portfolios.

8. Media skepticism: Navigate the noise

If it bleeds, it leads.

Media hype often distorts market realities, focusing on short-term drama and long-term speculation while ignoring the 3-30 month timeframe that matters most to markets. Developing a healthy skepticism towards financial media is crucial for contrarian investors.

Strategies for navigating media noise:

1. Focus on fundamental economic indicators like the Leading Economic Index (LEI)
2. Distinguish between short-term volatility and long-term trends
3. Be wary of "Dracula around the corner" stories that hype unlikely catastrophes
4. Look for disconnects between media narratives and market behavior

Red flags in financial media:

• Excessive focus on daily market moves
• Overhyped economic data releases
• Speculation about far-future events or societal issues
• Recycling of old fears and "cud-like" worries

By filtering out media noise and focusing on relevant, forward-looking information, investors can maintain a clearer perspective on market opportunities and risks.

9. Sector rotation: Capitalize on sentiment shifts

Leadership flips and flops.

Sector leadership changes over time, creating opportunities for contrarian investors who can identify shifts before the crowd. Understanding the cyclical nature of sector performance and the role of sentiment can provide a significant edge.

Key principles of sector rotation:

• No sector or style remains dominant indefinitely
• Shifts often occur when sentiment reaches extremes
• Economic cycles and policy changes drive rotations

How to spot potential rotation:

1. Monitor sector valuations relative to historical norms
2. Assess investor sentiment and positioning in various sectors
3. Look for fundamental catalysts that could drive change
4. Consider how economic and policy shifts might impact different sectors

Examples of sector rotation patterns:

• Small caps often outperform early in bull markets, while large caps lead later
• Cyclical sectors tend to outperform in economic expansions, defensives in contractions
• Value and growth styles alternate leadership over multi-year periods

By anticipating sector rotations, investors can position their portfolios ahead of major shifts and capitalize on changing market dynamics.

10. Value vs. Growth: Timing the leadership change

Value does great sometimes but not all the time—no one style is best for all time!

Style timing between value and growth can significantly impact returns, but it requires understanding market cycles and sentiment shifts. Neither style is inherently superior, and leadership tends to alternate over time.

Characteristics of value and growth cycles:

• Value often leads early in bull markets and during periods of economic recovery
• Growth tends to outperform later in bull markets and during periods of low economic growth
• Leadership changes can persist for several years

Indicators of potential style shifts:

• Extreme valuation disparities between value and growth stocks
• Shifts in economic growth expectations
• Changes in interest rate environments
• Investor sentiment reaching extremes for either style

To capitalize on style rotations:

1. Monitor relative performance and valuations of value and growth indexes
2. Assess current market positioning and sentiment towards each style
3. Consider how economic and policy changes might impact style performance
4. Be prepared to adjust portfolio allocations as leadership changes

Remember that being early in a style rotation is often better than trying to time the exact inflection point. Gradual shifts in allocation can help manage risk while still capturing potential outperformance.

Last updated: October 2, 2024