February Option Advisor: Beware Consensus Thinking

The accompanying chart tracks the performance of crude oil futures from the early 1990s to their climactic peak in mid-2008. The 1990s were a choppy period for crude oil prices, which traded mostly in the range of $16 to $24 (all prices quoted are per barrel). This range was broken to the upside in early 2000, and the advance gathered momentum through most of the current decade, culminating in the spike in 2008 that peaked in July near $150.

So, why am I conducting a guided tour of crude oil price action over the past two decades in a column devoted to stock market analysis? Because of the potential relevance to today's market of that little "X" marked on the chart in early 1999. It was in March 1999 - just a year before crude oil entered into its greatest bull market in history - that The Economist magazine informed us in a cover story that we were "Drowning in Oil" and that crude oil prices were headed for the single-digits. Here's the "money quote": "Now the long oil-price odyssey seems at an end. Since its peak in 1980, the price has fallen erratically. It has plunged by half in the past two years alone. In real terms, oil now costs roughly what it did before 1973. Crude is gushing from the ground at the rate of 66m barrels a day, half as copiously again as in OPEC's prime. The world is awash with the stuff, and it is likely to remain so. That is good news, is it not? For consumers, certainly, especially those in poor countries whose lives will be improved by the warmth, light and mobility that cheaper energy brings. It would be progress, too, to get away from the notion that oil is scarce-an assumption that led to two decades of energy-policy mistakes, such as subsidizing coal and nuclear power."

Yes, this view was horribly wrong in every respect, but what's my point? It's simply that magazine cover stories are often the best representations of "consensus thinking," and consensus thinking is, way more often than not, horribly wrong at major turning points in the markets. And that you should be alert to the strong possibility that in their Jan. 11, 2010 cover story entitled, "Bubble Warning: Why assets are overvalued," our friends at The Economist may be repeating the debacle of their crude oil forecast just a shade over a decade ago.

According to this piece, "Stock markets are still shy of their record peaks in most countries. The American market is around 25% below the level it reached in 2007. But it is still nearly 50% overvalued on the best long-term measure, which adjusts profits to allow for the economic cycle, and is on a par with two of the four great valuation peaks in the 20th century, in 1901 and 1966 ... Investors tempted to take comfort from the fact that asset prices are still below their peaks would do well to remember that they may yet fall back a very long way. The Japanese stock market still trades at a quarter of the high it reached 20 years ago. The NASDAQ trades at half the level it reached during dotcom mania. Today the prices of many assets are being held up by unsustainable fiscal and monetary stimulus. Something has to give."

Does this gloomy view of the stock market represent consensus thinking? I believe so, as it is articulated over and over in the financial media by those who have become the "opinion leaders" - individuals like Nouriel Roubini, the economist who "called the asset bubble" and whose media worship includes a personal portrait in GQ magazine. And Mohamed El-Erian, CEO of Pimco, whose total assets under management recently swelled past the $1 trillion mark. And proof of the pervasiveness of this skeptical viewpoint is the fact that individual investors are still withholding new money from U.S. stock funds, despite a rally whose magnitude in past years would have created a flood of dollar inflows. This leads to my next point - the fact that this consensus bearish view of the U.S. stock market is counter-trend, which makes it all the more remarkable and all the more actionable from a contrarian standpoint.

That all said, some caveats are in order. The S&P 500 Index has been stuttering and stumbling this month as it has approached its key 160-month moving average north of 1,150, and there is certainly the possibility of a tradable pullback if this is in fact a failure at this important level. And even though the March 1999 Economist piece pretty much tagged the precise bottom in crude oil, a contrarian take on magazine covers (and note that there are many publications in addition to The Economist whose cover stories can work as contrary indicators) requires patience, as the market often moves in the direction of the consensus over the short term. But on balance, investors should take comfort from all those pretty blue bubbles that recently graced that cover of The Economist.

"S&P failure pointing down, sentiment pointing up...next week might show which is right short term. Meanwhile by the time our anti-business congress figures out how to get out of the way it will be to late for stocks. By then interest rates will climb faster than earnings."
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"Any posts here about"
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"While the anecdotal evidence could be right, in the final analysis what determines the direction of the market is fundamentals. And they are at the present none too good, what with the US Govt. printing money like there is no tomorrow (other countries are also on the same spree) and what with the state of economy of most of the countries - the situation in terms of magnitude of disaster the world has just seen is worse than the Great Depression days. And what is worse, the US Govt. is administering the same 'medicine' for the disease that caused the disease in the first place. I am no bear and I fervently hope and pray I am wrong in my this opinion."
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