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Investing at the point of maximum pessimism

If you want to know how to make these troubled markets work for you, says this U.S. advisory, follow some of the best advice in history.

Today’s headline comes from the most famous saying of the late Sir John Templeton. It seems timely enough, since the behaviour of the markets these past few days ought to induce plenty of pessimism.

But Bob Carlson’s Retirement Watch is not so sure we have reached that pessimistic turning point. The editor of this advisory doesn’t just mine Sir John for impressive quotes, but credits the legendary investor for “the foundation of our winning investment strategies.”

Mr. Carlson gives us a concise account of the Templeton approach to the stock market and applies it to today’s conditions. In the process, he addresses two burning questions. Is the market reaching bottom? Is it time to buy now?

Actually, Mr. Carlson divides the credit for his investment approach between Sir John and the late Mr. Benjamin Graham, author of The Intelligent Investor.

The first conclusion to be drawn from these investment gurus: the markets aren’t perfect.

An inspired forecast

Neither Sir John nor Mr. Graham believed that investment markets are fully efficient. “They believed emotions and mistakes periodically pushed asset prices to extremely high or low prices that were out of line with fundamentals and likely future prices,” says Mr. Carlson.

“They believed in selling an asset when most investors were extremely optimistic and buying when most investors were extremely pessimistic.”

Over the long term, however, Sir John Templeton was an optimist. And that inspired one of this editor’s successful forecasts.

In 1991, Mr. Carlson predicted that the Dow Jones Industrial Average would hit 6,000 by the year 2000 (it stood at 3,000 in early 1991).

“That seemed a rather outlandish forecast at the time,” says the editor. “Inflation was high. We were only a couple of years into a great bull market, which many doubted was durable. Most investors then viewed stocks only as trading vehicles. Yet, the forecast turned out to be not optimistic enough.”

The Dow soared past 6,000 in 1996 and by the turn of the century had crested above 11,000, not far from where it is today.

But tough times will come knocking at regular intervals, which prompted Sir John to utter his famous maxim: “Buy at the point of maximum pessimism.”

Margin of safety

When times get tough, safety comes first. And Mr. Benjamin Graham coined a phrase of his own, “margin of safety.” He meant that “after a thorough analysis the investor should believe principal would be safe and there would be a satisfactory return.”

That safety cannot be absolute, of course. An investor can lose everything. But he or she must believe that the principal is going to be safe under reasonably likely conditions.

So would these two giants be big buyers of financial assets today, Mr. Carlson asks himself? “We don’t know; we can only apply the principles they laid out.”

It is the editor’s opinion that we have not reached the point of maximum pessimism, all the current gloom and doom notwithstanding. “Many investors are willing to purchase new assets at each new low in hopes of capturing big gains.”

A bottom to the market may be forming, but there are too many unknowns to be confident, says Mr. Carlson. One or more markets could freeze again, just like they did in 2007.

“Financial institutions do not know the value of many assets they own,” the editor asserts. “Until the housing and mortgage markets become stable, many variables are likely to remain unstable and unknown.”

There is no margin of safety to rely on.

Not the whole story

Two positive changes have occurred, says Mr. Carlson. Oil and other commodities have retreated in price and the U.S. dollar has risen above its lows. (These are mixed blessings north of the border, of course, but not without benefits for many.) Since these two things happened almost simultaneously, the editor believes they are related.

While these two developments should provide a boost to the economy, they do not tell the whole story.

The markets today, insists the editor, closely resemble those of the early 1990s. In the early 90s, a host of problems beset financial markets — a bond meltdown, a real estate decline, falling energy prices and the collapse of the tax shelter industry. To which you can add the brief but disruptive Gulf War. “It took a long time to work through the problems that began in the late 1980s,” Mr. Carlson reminds his readers.

Yet many persist in comparing today’s troubles to those of the late 1990s and early 2000s, which were resolved much quicker. Many forget that recoveries from widespread systematic problems can take more time. And that’s what we’ve got today.

Believe the credit markets

“Reliable estimates are that only about half of the likely losses from the mortgage and credit crises have been taken,” the editor states.

That means America is still faced with reduced lending and borrowing, and that usually means reduced economic growth. So even though the stock markets suggest we’re charging toward the end of the crisis, the credit markets do not. “Credit markets, though not reliable forecasters, are better indicators of current conditions and the outlook than stocks.”

We are about halfway through the process of refilling the hole in the housing and credit markets, Mr. Carlson concludes. When investors start moving assets from treasury bonds, and when the commercial paper market revives, things will be looking up.

The market shocks of the last three days may indicate that we are getting closer to maximum pessimism (or at least maximum panic).

But if this advisory is right, there are still more problems to be worked out. While we cannot consult Sir John or Mr. Graham on today’s problems, we can be pretty sure they would advise investors to keep calm when all around you are rushing madly about.

Make very sure that the market has hit bottom before you start reaching for the top.