When to follow the investment herd

"The crowd is untruth," wrote philosopher Soren Kierkegaard, a proponent of individualism. Existentialism is not much followed by financial markets, but investors should be alert to the dangers of groupthink in the year ahead.

The past year showed again why it often hurts to be part of the herd. At the start of the year the 10-year US Treasury bond yield was 3 per cent, and few expected yields to fall. In a January survey of economists by Bloomberg the average forecast was a yield of 3.5 per cent by the end of this month, with the lowest prediction being 2.5 per cent. As it is, yields stand at 2.3 per cent, and the fund managers who eschewed bonds missed out on returns that have rivalled those of equities, with less volatility.

As the year draws to a close, some of the most crowded trades have emptied a little, as the sharp jump in volatility in December prompted hedge funds to cut back risk taking. Even so, investors and economists seem to share a single economic outlook.

The most obvious case of herding is into the dollar, and out of the euro, yen and emerging markets. Investors are betting on the "divergence" between the economies of the US and the rest of the world which features in almost every 2015 outlook from Wall Street strategists.

"The biggest consensus by any margin is to be long dollar, short euro," says Yves Kuhn, chief investment officer at Banque Internationale a Luxembourg. "And that's the scariest because I have never seen such a consensus in the market."

Belief in a strong dollar had faded as it resolutely refused to rally, against the euro in particular, for three years until this summer. But after a 10 per cent jump in six months, the third-biggest over such a period since 1997, the greenback has won over doubters.

Economists are almost unanimous in their support for the US. All those surveyed by Bloomberg expect 10-year yields to rise over the next year, and all but three of 94 thought US growth would be above 2.5 per cent, a level last reached in 2010.

Ewen Cameron-Watt, chief investment strategist at the BlackRock Investment Institute, says this leaves investors vulnerable to any surprise, especially with the eurozone current account surplus helping to support the euro. "The risk is that Europe's economy is a little bit better than expected and QE proves just a little bit hard to deliver," he says.

When investors are heavily committed to a view, news suggesting it might be wrong tends to create an outsize reaction, leaving a risk of sharp reversals for the dollar.

The strong dollar view is behind the large bets on interest rates rising, and so on two-year and 10-year US bond prices falling (as yields rise). Hopes of a weak yen are behind heavy bets on Japanese shares going up, with the biggest-ever long position by speculators in Nikkei 225 futures recently.

While contrarians worry about the crowd, some think the herd will get far bigger before it disperses.

"I think the dollar's on its way to being really really overcrowded," says Richard Bernstein, founder of Richard Bernstein Advisors, who expects the dollar to strengthen further. "The line's forming outside the theatre but I don't think there's a mad rush yet."

Other notable crowded trades include the bet on India, where shares have soared by a fifth this year and the rupee has fallen less than other emerging market currencies. If Narendra Modi, prime minister, fails to push through his reforms as fast as investors expect, "Modinomics could be a replay of [Japan's] Abenomics" and the consensus would be disappointed, Mr Cameron-Watt says.

The bigger picture is that both professional investors and wealthy ones are committed to shares and deeply sceptical of bonds. A survey this month of fund managers by Absolute Strategy Research and Extel found investors put a 75 per cent probability on shares beating bonds, even though more than half think equities are expensive and only 10 per cent think they are cheap.

Simon Smiles, chief investment officer for ultra high net worth at UBS, says an event the bank hosted for investors showed the consensus. "Every single person was long equities and short government bonds," he says. As a result, "the sensitivity to any kind of negative news on economic growth we believe will be greater".

Unfortunately, there is no guarantee that the crowds are wrong. While this year the contrarian approach worked out well, crowded trades sometimes result merely in short, sharp reversals on the way to being proved right.

Kierkegaard might approve of the tricky decisions investors face. "Do it or do not do it," he advised gnomically. "You will regret both."

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