How To Avoid Wall Street Groupthink

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Brett Arends at MarketWatch published a great article on Thursday that highlighted the worst calls by Wall Street money managers so far in 2014. His article confirmed two of our long-standing arguments, thatactive management tends to underperform, and that buying assets based on past performance is a recipe for disaster.

In particular, Arends’ article noted that money managers came into 2014 overweight Japan and underweight emerging markets. These same money managers had been burned when they came into 2013 bearish on Japan and bullish on emerging markets only for the former to outperform and the latter to tank. Sure enough, the money managers got it wrong again this year. Japanese equities have been among the worst performing asset classes this year while emerging markets have comfortably outperformed.

This delayed reaction is not unique to money managers. Too often average investors fall into this same trap of buying stocks and ETFs based on past performance rather than on real research into earning and valuation. So, everyone who owned high momentum stocks that crashed this year can feel good about being in the same boat with the “smart money”. Unfortunately, the smart money is not always that smart.

So, how can investors avoid falling into the same trap?

The answer is simple. Do your own diligence and don’t pay attention to the noise surrounding high momentum stocks and assets. We don’t cover emerging markets or Japanese equities, but in the U.S. stock market we’ve seen several cases over the past few years where fundamental research was able to cut through the momentum buzz.

LinkedIn LNKD, Angie's List ANGI, and Dunkin Brands DNKN were all high flyers when we issues short calls on them. LinkedIn and Angie's List had both risen by over 100% in the prior year when our articles came out while Dunkin was up 36%. All three have fallen by more than 10% since, with ANGI leading the way with a nearly 50% drop.

On the other side of the coin, several stagnant or slumping stocks that we called long soon shot up for big returns. Western Digital WDC had been flat for three years when we recommended it in 2012. Since then it's up 150%. DirecTV DTV had been flat for three months during the bull market of last year when we recommended it to investors, and it's handily outperformed the market with a 40% gain since. Finally, Seagate Technology STX had dropped 30% in the three months before we called it a buy. It's gained 363% since then and still earns our Very Attractive rating.

Doing your own fundamental analysis can be hard work, but as Figure 1 shows, it is worth it. Listening to the buzz on Wall Street only tells you what has outperformed, doing your own research can tell you what will outperform.

On that note, let’s look at some ETFs that look set to reverse recent trends and either over or underperform the market going forward. Unlike most ETF ratings that are based on past performance, our predictive ratings are based on our fundamental analysis of the holdings.

One underperforming ETF that we like going forward is the State Street SPDR Insurance ETF KIE. KIE is down ~1%, this year, but it has an extremely strong portfolio. Over 50% of its holdings earn our Attractive or Very Attractive rating, led by its top holding, Aspen Insurance AHL, one of our Most Attractive stocks.

On the other side of the coin, the iShares Dow Jones US Oil & Gas Exploration ETF IEO is up 11% in 2014 but earns our Very Dangerous rating. 88% of its holdings earn our Dangerous or Very Dangerous rating. On average its holdings have a price to economic book value ratio (PEBV) of 4.7, nearly double that of the S&P 500 at 2.5.

Oil and gas stocks may be hot right now, but following the crowd into this sector looks like a good way to lose money. No one is hyping up the insurance sector at the moment, but for long-run returns it looks like a good place to be.

Sam McBride contributed to this report.

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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