How to gain an edge in investing by defying conventional wisdom

A trader works on the floor at the New York Stock Exchange. Never presume common wisdom about what is good or bad for capital markets is correct. Reuters

High price-to-earnings ratios. Seasonal return adages. Tax rises. A weak (or strong) dollar. What do they have in common? Conventional wisdom claims all are bad for stocks.

Most investors accept that unquestioned. Don’t. Things “everyone knows” are very often provably wrong. Getting that right gives you an edge. It isn’t hard to do. Never presume common wisdom about what is good or bad for capital markets is correct. See it as a theory to test like a scientist should. Here is your “laboratory” for doing just that.

Little we see is truly unprecedented. So, you can easily test most basic claims against historical data. Many prove false.

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Example? An ancient market myth argues January’s returns predict the full year’s. Good January, good year. Bad January, bad year. This is simple to test with historical stock returns.

Consider America’s S&P 500 index in USD for its long and accurate history. Monthly data begins in 1926. Since then, January and the year were positive 52 times – 53 per cent of all years. Does this “prove” January’s predictive power? No. It simply shows you stocks are positive more often than not historically.

The least common occurrence is a positive January preceding a down year – nine times. But a negative January preceded a down year seven times – slightly less often than it preceded an up year, 21 times. Not predictive or far off from a coin flip. Any “strategy” reliant on cherry-picked data, like this so-called “January effect”, isn’t viable.

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Or consider the widespread belief that high price-to-earnings (P/E) ratios hurt stocks and low P/Es are good. We can disprove this in our market laboratory also.

Since 1926, US stocks’ average 12-month trailing P/E (price divided by the last 12 months’ earnings) is 17.7. Monthly P/Es topped this 476 times through May last year. Over the next 12 months, the S&P 500 fell 139 times and rose 337 times – a 70.8 per cent frequency of gains. The opposite of conventional wisdom.

And for the 705 months with below-average P/Es, the next 12 months rose 78.4 per cent of the time. Together, this just shows you, again, that stocks rise much more often than not. Regardless of P/E. That’s it.

History shows many “common sense” popular beliefs are false. Tax rises? Not reliably, repeatedly bad for the US, global or any major stock market. Britain lives this now, with stocks up nicely despite an April tax rise. Same with fears around high government budget deficits. Natural disasters. Trade deficits.

Endless misperceptions hold for currency swings, too – up or down. Many fear the US dollar’s recent “weakness”, claiming it portends the currency’s global reserve status ending or that global confidence in America is gone – supposedly boding ill for US stocks.

In the US and globally, weak currencies also fan fears of higher import costs fanning domestic inflation. Meanwhile, strong currencies spur endless fretting, too. European nations now fret importing deflation and slow growth as their currencies strengthen.

But history shows stocks rarely react – regardless of the dollar or other currency’s strength or weakness. Since 1973, when the index measuring the US dollar against a trade-weighted currency basket begins, the greenback weakened in 18 years. Stocks fell with it just two times … and rose 16 times.

Now, that doesn’t mean a weak currency is automatically bullish. But it certainly isn’t bearish – and undercuts common “wisdom”. Conversely, the dollar strengthened during 33 years since 1973. US stocks rose with it 25 times and fell eight times.

All of this simply aligns with stocks’ average frequency of returns throughout history. There is no investing strategy to glean here.

No, history doesn’t repeat perfectly. But investing isn’t about certainty, ever. It is about probabilities. And history frames probabilities. If people say Thing X is bad for stocks, but X preceded good returns 70 per cent of the time, you absolutely know there is a high probability X isn’t bad.

You can’t dismiss it, but you can study what else happened during the 30 per cent of history when X seemed bad. Maybe it was coincidence. Maybe you find Thing Z was also afoot, so you look at whenever Thing Z happened to see if it is reliably bad. If it is, and you can find a good, economically sound reason for why it would be bad, then you have precious information few others do. Another powerful edge to do better than others will.

Even simply proving popular claims aren’t true gets you well ahead. Markets pre-price widely known information, including popular beliefs and myths. When you can invest knowing common wisdom is wrong, opportunities abound to ride stocks’ positive surprise.