ebook essays pieces of the puzzle
Wednesday, January 26th, 2011
consensus trades

Starting the new millennium, the consensus trades were technology and financial stocks.  The Internet revolution had become the dot-com bubble and the bull market in stocks and bonds led to great faith in financial alchemy.  Investors positioned themselves accordingly.

It didn’t turn out too well, as you can see from the performance of the ETFs representing those sectors, XLK and XLF.  (Shown above are the cumulative total returns for all nine of the Select Sector SPDR funds.)  Technology stumbled out of the gate, but the financials continued their strong performance until a bit of unpleasantness starting in 2007 unmasked the risk-taking that had been driving the sector’s profits.

Now the consensus trades are energy and basics (XLE and XLB), which have demonstrated the best relative performance looking backward — and have reasonable investment theses going forward, what with strong global demand, apparent supply constraints, and central bankers keeping interest rates low.  The stories sound good (they always do), and consensus trades can work for a long time.  But the chart above provides a cautionary tale about what happens when they come apart at the seams, and a reminder that risk management is something you should be doing when you feel like you least need it.  (Chart:  Bloomberg terminal.)