"The Consensus"

This past week, I got a chance to speak with a very interesting gentleman. His name is Ken Grant and he's the author of a terrific new book titled "Trading Risk." Ken is a major player when it comes to risk management in the hedge fund industry. How big of a player is he? Well, in his career he has worked as the head of risk management for both Tudor Investments and the Chicago Mercantile Exchange. He was also the chief investment strategist for SAC Capital Advisors, one of the largest hedge funds in the world, with over $4 billion under management. Obviously when this man talks, it pays to listen. And this past week, I got that chance to listen. The entire interview will be published next month on www.RealWorldTrading.com. But, I want to focus on one small part of our conversation because it has a great deal of significance.

4 Pieces That Create The Opportunity

Ken believes in the efficient market theory (he has his MBA from the University of Chicago Graduate School of Business, so that makes a great deal of sense). Late in the interview he said something which gave me pause for thought--he told me that one of the few places he saw a real edge on the trading side occurred during the reactions after the consensus was wrong. His reasoning was as follows (and please note that some of this is my interpretation of our discussion):

1. Most of Wall Street is made up of consensus traders. You have an entire industry that has been trained to see things essentially the same way at approximately the same time.

2. When an event occurs that differs from the consensus, the herd needs to adjust their position to reach a new consensus. But, in doing this, it sometimes creates a panic.

3. This panic creates an even bigger panic because after the position moves dramatically against institutions, it then triggers a panic amongst the risk managers of these funds. Their panic then creates an even greater and more exaggerated move in the stock (this doesn't always happen at once-it sometimes takes days or longer to unfold).

4. This final panic then creates the opportunity. This opportunity is then exploited by the few "smart traders" who have the capital and the brains to step in and take advantage of the situation.

Theoretically, this makes a great deal of sense. And, having worked with some of the best traders in the world at Tudor Investments and SAC Capital, he's had a chance to personally witness this.

A few days before I spoke with Ken, I got a chance to watch (and participate) as this phenomena unfolded. Think back a week and a half ago and remember how the semiconductor industry was getting slammed. The SOX was making low after low as "the consensus" was expecting the worst. And then, on September 9, National Semiconductor reported earnings higher than "the consensus" and Texas Instruments around the same time made a few comments that was better than "the consensus" and before you know it, the race was on. Over the next 3 days NSM rose nearly 25% as many of those "consensus" non-buyers (and sellers!) of a few days before changed their mind and started buying again along with the short-sellers (who were caught up in the negative consensus) who began covering their shorts and before you knew it the buying rampage was on.

Here is the chart:
 

There's A Lot of Wisdom To This Man's Words

Obviously trading isn't always this simple. Contrarian thinking is certainly not difficult (even my teenager has that game down pat), but understanding the behavior of the market at extremes is an art. Knowing when "the consensus" is going to be wrong and how to exploit it is not only an art, it's a science. Those few people who were smart enough to read the panic selling in the semis and were smart enough to accumulate stock near the lows were handsomely rewarded over the past week and a half. And if this stock market rally is for real, these stocks will lead these buyers to even greater gains.

The game is to have the knowledge (and the guts) to know when cheap, really is cheap. Coke (KO | Quote | Chart | News | PowerRating) is a good example. Was this past week's selling "consensus panic selling"? I don't know. But when you see a Blue Chip stock getting slammed, as we saw with TXN, NSM, KO and others, it's many times because the consensus was wrong, panicked and created a short-term buying opportunity that has the potential for quick, outsized gains. Ken Grant has seen it, we just saw it in the semis, and we'll certainly see it over and over again in the future.

Ken's entire interview will be published on Real World Trading next month. In the meantime, I hope this small piece of our discussion gives you something tangible to think about, and something you can use in your own trading.

Have a great week trading!

Larry Connors