25% In Three Days? Here’s When It Happens

“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
” 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
. 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
. 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
reported earnings higher than “the consensus” and Texas
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
cheap. Coke
KO |
Quote |
Chart |
News |
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
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

Have a great week trading!

Larry Connors